Using Percentage Rent in a Commercial Real Estate Lease
There are an almost infinite number of variations that commercial leases can take, with each property type having their own nuances as to the structure of the leases. This article will discuss one such nuance that is primarily used for retail properties – percentage rent.
What is Percentage Rent?
The concept of percentage rent is relatively straightforward. In addition to the minimum rent that a tenant pays, percentage rent requires the tenant to pay a certain percentage of their sales as additional rent to the owner of the property. The thought is that if the store does really well then the owner of the property should also benefit from the business doing well.2
This makes sense when you consider that the physical condition, tenant mix, and overall shopping experience can make a big difference in the draw to a retail center, increasing the number of visitors and money spent at that center. Ensuring a good experience falls largely on the owner of the property. So if an owner procures a really good mix of tenants, keeps the property maintained, and offers a good experience, it follows that the tenants in the center will most likely benefit from more traffic and higher sales. The owner then gets to participate in the upside achieved from those higher sales.
Example of Percentage Rent
At this point it would be helpful to look at an example of how percentage rent can be applied. As discussed later, the exact terms of the percentage rent clause can be and are negotiated, so keep in mind that the numbers used below are for illustrative purposes only and should not be taken for market standards.
Let’s say a retail tenant leases 4,800 square feet and pays $10 per square foot per year in minimum rent (see the table below for a visual breakdown of these calculations). This means the tenant is paying $48,000 per year, or $4,000 per month in minimum rent. In addition to minimum rent, the owner and tenant agree to a percentage rent provision of 5.0% of gross sales above $500,000. This means that if the tenant has gross sales of $600,000 for the year, then the tenant pays additional rent of $5,000 [($600,000 – $500,000) x 5.0% = $5,000]. If, however, the tenant does not achieve gross sales above $500,000 then no additional rent will be owed to the owner of the property.
In the section above, we discussed two concepts. The first was the percent of sales the tenant paid to the owner. The other was the threshold above which the tenant must begin paying a percent of gross sales as additional rent. This threshold is known as the “breakpoint.” The example below shows how these figures are calculated.
There are two common types of breakpoints: one is the “natural” breakpoint and the other is sometimes called the “artificial” breakpoint. The artificial is an arbitrary number reached through negotiation. We’ll first give an example of an artificial breakpoint because it’s a little more straightforward and most closely resembles the example given above. Then we’ll discuss the natural breakpoint in more detail.
Recall that the “breakpoint” is the amount of gross sales above which a tenant must pay additional percentage rent. In the case of an artificial breakpoint, the owner of the property and the tenant agree on what amount of gross sales will serve as the breakpoint and what percent of additional sales above the breakpoint will be paid as additional rent. This could be a breakpoint of $100,000 or $20,000,000 and the percentage could be 3% or 7% or something else. It all depends on the specifics of the property and other aspects of the lease, but should be reasonable given the size and expected gross sales of a tenant.
In the example above, the owner and the tenant agreed on an artificial breakpoint of $500,000 with a percentage rent rate of 5.0%. Gross sales of $600,000 resulted in a $100,000 overage of the breakpoint. The 5.0% percentage rent rate was then applied to the overage amount of $100,000 resulting in $5,000 in additional percentage rate paid by this tenant.
The natural breakpoint occurs as a result of the relationship between the percentage rent rate and the minimum rent owed by the tenant.
As can be seen in the table, the natural breakpoint is the minimum annual rent divided by the percentage rent rate (minimum rent / percentage rent). The logic of the natural breakpoint is that the breakpoint should be the amount that allows the tenant to pay the minimum rent at the specified percentage rent rate. If the business achieves gross sales above the breakpoint, then the additional percentage rent will be applied to the overage amount.
Audits and Reporting
The fact that the owner of a property (who usually is not an owner of the retail establishment operating on the property) is entitled to some of the sales of the business leads to issues around reporting and transparency in the sales of the retail business. For this reason, owners require tenants to regularly report sales and allow auditing of sales that occur at the location. Often owners will also require the retail business to ensure no other locations are opened within a specified area to prevent cannibalization of sales.
Just like any other real estate transaction, each side has motivations and there are often lease structures that benefit one party more than the other. For example, an ideal situation for owners would be a high minimum rent and a low breakpoint with a high percentage rent rate applied to gross sales above the breakpoint. Tenants would prefer low minimum rent with a high breakpoint and a low percentage rent rate applied to gross sales above the breakpoint. In most cases the outcome is somewhere in the middle, but what should you look out for and negotiate along the way?
Often tenants can agree to a higher minimum rent in exchange for a higher breakpoint or lower percentage rent rate. Sometimes, however, tenants may want the opposite arrangement for strategic reasons. Take a new retail business in a new location, for example. As a new business, the tenant probably wants to keep expenses as low as possible and is not expecting high gross sales for the first few years until the business becomes established. In this situation, the tenant may push for a low minimum rent (at least in the first few years) in exchange for a higher percentage of gross sales down the road once the business starts doing well.
The inclusion of a percentage rent clause can be mutually motivating for both the owner and tenant of a property. If an owner receives additional income from operating a high-quality retail center, the owner is more likely to pursue physical and economic improvements that increase traffic and spending. Percentage rent can also be a tool that allows tenants to get established by avoiding high upfront costs in exchange for higher expenses down the road. In any case, the individual circumstances of each tenant and owner should be considered in any negotiation for percentage rent (and all other terms, for that matter).