In the previous article, we have already seen what a variable lease is and how it is different from traditional leases which are used by retail companies across the world. We are now also aware of the manner in which variable leases are structured.
We know that the popularity of variable leases has been rapidly increasing over the last few years. In this article, we will have a closer look at the pros and cons related to variable or percentage-based lease arrangements between landlords and retail companies.
Advantages of Variable Lease
The main advantages of variable leases have been mentioned below:
- Shared Goals: It is important to note that first and foremost benefit of having a variable lease is the fact that the goals of the landlord and the retail company become aligned.
The landlord is no longer interested in benefitting at the expense of the tenant. This is because of the fact that their rent will only go up if the sales go up. As a result, landlords tend to become more co-operative and provide all the required facilities which enable the sales of the store to increase over a period of time.
- Equitable Distribution of Risks and Rewards: In a traditional rental situation, the risks related to the business are solely borne by the retail company. This is not correct since the landlord also have a major stake in the business and can influence the health of any retail store. As such, tenants become overburdened with excessive rents in traditional agreements.
The percentage based variable method ensures that both the landlord and retail company share the profits made in the upside as well as the risks borne if the business makes losses.
- Operational Flexibility: Variable rental agreements are very important for retail companies since they allow such companies to better manage their cash flows.
In months where the sales go down, the rental expense also goes down. As a result, the retail company gets a cushion and is not immediately pushed into financial disarray.
- Resilience: It is also important to understand that percentage-based sales agreements help retail companies become more resilient. Such agreements allowed companies to stay afloat even when their business was under a threat of total collapse during the covid-19 pandemic.
Retail companies are willing to pay a higher percentage as lease rentals if they get they flexibility to alter the rental payments during times of distress.
Disadvantages of Variable Lease
There are several disadvantages related to this method as well. Some of the disadvantages have been mentioned below:
- Determining What Constitute Sales: The first problem associated with variable lease rentals is the fact that sales can difficult to determine. There can be varying definition of sales in the retail industry.
Firstly, the landlord as well as the retailer need to ensure that they clearly define what is meant by sales with respect to the lease rental agreement. However, even if they make an attempt to clearly define what is meant by sales, there is still room for ambiguity. There is always a possibility that the contract might be legally challenged by either party at a later date.
- Verification of Sales Data: Secondly, even if both the parties somehow agree on a crystal-clear definition of sales, verifying the actual sales data is still problematic. The retail company has complete control over the first-hand source of sales data.
Hence, the landlord always has to face an information asymmetry. There is a slight chance that the data might be manipulated by the retailer in order to pay a lower rent. To prevent this, the landlord has to ensure that they have the administrative capability to monitor the sales data. This is an added expense for the landlords and hence is considered to be a disadvantage.
- Sharing of Financial Information: There are many retail companies in the world who do not want to share their financial information.
Sales based rental agreements make it necessary for such companies to share their financial information with a third party. The sharing of this information means that there is always a chance that it can reach the hands of competitors. Many retailers want to keep their information private and hence are opposed to sales based variable rental agreements.
- Less Stability for Landlords: It is also important to note that there is no stability in terms of rental receivables. It needs to be understood that the rentals of the landlord are likely to reduce at the same time when the overall economy is in a bad condition.
Hence, the overall financial position of the landlord ends up being negatively impacted. There are many landlords who prefer receiving a stable rent as opposed to taking on the vagaries of the marketplace.
- Inability to Finance Receivables: Last but not the least, it is common for landlords to discount the lease rentals which they are likely to receive in the future. In case of variable lease rentals, the exact future amount which will be received as a lease rental is unknown. It is for this reasons that these amounts cannot be discounted.
Banks and other financiers are only willing to discount the base rent and provide cash to the landlord in the form of a lumpsum. The inability to raise finances using lease rental discounting means that the landlord has to rely in expensive financing in order to meet their financing needs.
It can therefore be said that sales based variable rental agreements have both pros as well as cons. The applicability of these pros and cons depends upon the financial goals and risk appetite of both parties.
