The following is an excerpt from Jamie Moorhead's new book, Tenant Leasing 101, now available in paperback and Kindle formats on Amazon here:
In a retail lease, the three typical types of rent are base rent, additional rent, and percentage rent. Percentage rent is rent based on a percentage of the gross sales that tenant earns while operating its business at the site. Percentage rent may sound straightforward, but there are several things to consider in order to fully understand it.
Purpose of Percentage Rent
A retail landlord is spending time and money to make the shopping center as attractive as possible for customers. The goal of this effort is to maximize store sales for the tenants. In return, retail landlords desire to be compensated for the effort and will look to percentage rent as the way to receive a share of the store profits.
Percentage rent is calculated by multiplying an agreed-upon percentage by a store’s gross sales that exceed a certain, pre-determined threshold. The agreed-upon percentage typically is 5-6% and is called the “percentage rent rate.” The pre-determined threshold typically is the “natural breakpoint.” This natural breakpoint will be the amount equal to the quotient obtained by dividing the annual base rent by the percentage rent rate. This is a technical section of the lease and should be reviewed carefully.
When it is used, landlords may be willing to lower the monthly base rent amount (the thinking being that what a landlord may lose in monthly rent, it likely will make up based on store sales). If a company is nervous about opening in a new geographic area or in a new location, it may be worthwhile to consider thinking through the base rent-percentage rent structure. If a tenant secures a lower month rent because of percentage rent and the store’s sales then do not exceed the percentage rent breakpoint, this may be a cost-effective rental strategy for a tenant.
In drafting percentage rent provisions, it is important for the parties to consider the types of sales that will be included in the calculation of gross sales and the timing for the payment of the percentage rent. A few things can be considered:
- Exclusion from “Gross Sales”: Just as specific items can be excluded from common area maintenance costs, specific items also can be excluded from gross sales. By excluding these items, the amount of gross sales will be reduced, as well as the amount of percentage rent that is calculated on these sales.
- Calculating and Reporting: In an ideal percentage rent provision, the percentage rent is calculated and paid annually. If this is not possible, the lease then should state that the percentage rent is calculated annually and paid beginning in the month in which the natural breakpoint is met.
- Unfair Proration: Some landlords will want the tenant to pay on a prorated basis for a partial year. This can be acceptable, but keep in mind that if a tenant opens its store just before the Thanksgiving and Christmas holidays, the gross sales could be unusually high during that period. This would unfairly trigger percentage rent and should be avoided or addressed.
- Fiscal Months: A diligent tenant also may require that the gross sales reporting be done on a fiscal month basis, not a calendar month basis. Weekends typically have a higher sales volume than weekdays. Some calendar months have four weekends, and some have five. To address this inconsistent between months, the fiscal month calendar alternates between four week months and five week months. This fiscal month reporting will more accurately reflect the amount of gross sales during any given period of the year.
To maximize the potential percentage rent payable to the landlord, a landlord might require the tenant to do a few things: continuously operate in the premises, not open another location in close proximity to the shopping center, and permit the landlord to audit the gross sales. Also, retail landlords may require gross sales reporting even if no percentage rent is required. The purpose of this is to keep close watch on the tenant’s financial health and to anticipate finance-related problems.
This obviously can be a very complicated provision in the lease, and an appropriate attorney can be consulted for guidance.
For more, please visit Tenant Leasing 101 on Amazon here.