Understanding Percentage Rent in Retail Leases
11/2/2016 | Articles & Alerts
In consideration for creating and owning a shopping environment that will generate gross sales for a tenant, landlords often want to share in the financial success of a tenant’s store. In order to share in such success, landlords can negotiate for percentage rent provisions to be added in their leases. A percentage rent provision provides that if the tenant achieves a certain amount of gross sales in a given year, they will pay a percentage of such gross sales to the landlord as additional rent.
In a lease with a percentage rent provision, the landlord will receive a minimum amount of rent (called the annual fixed rent or annual minimum rent) and, in the event the tenant’s gross sales increase over a certain amount (sometimes called the “breakpoint”), the landlord will also receive a certain percentage of the gross sales over the breakpoint. If the parties intend that the landlord should receive a certain percentage of the tenant’s total gross sales, then a “natural breakpoint” will be used. A “natural breakpoint” is the amount of gross sales that, when multiplied by the applicable percentage, equals the amount of annual fixed rent [natural breakpoint x _____% = annual fixed rent]. Stated another way, it is determined by dividing annual fixed rent by the applicable percentage [natural breakpoint = annual fixed rent ÷ ____%].
For example, if the landlord and the tenant agree that the landlord should be entitled to 5% of the tenant’s total gross sales, but not less than the annual fixed rent, the parties would add a percentage rent provision to the lease providing that the tenant will pay to the landlord percentage rent in the amount of 5% of the tenant’s gross sales over the natural breakpoint. If the annual fixed rent in the foregoing example is $100,000.00, then the natural breakpoint would be 100,000 ÷ 5%, or $2,000,000. Therefore, the tenant would be obligated to pay to the landlord 5% of its gross sales to the extent the gross sales are in excess of $2,000,000.
Putting this example to work, assuming that the tenant achieves $3,000,000 of gross sales in a certain year, the landlord and the tenant have agreed that the landlord is entitled to 5% of such gross sales as its total rent for the space, or $150,000.00. The tenant, however, will have already paid $100,000 in annual fixed rent. The amount of percentage rent would be 5% of the amount of gross sales over the foregoing $2,000,000 natural breakpoint (or $1,000,000) and will equal $50,000. Accordingly, the landlord will receive $100,000 in annual fixed rent and $50,000 in percentage rent, for a total of $150,000, which is the same amount as 5% of the tenant’s total gross sales.
Since many tenants will be profitable at a lower gross sales volume than the natural breakpoint, landlords can sometimes negotiate for a breakpoint lower than the natural breakpoint. In the alternative, a tenant might agree to pay a higher amount of fixed rent than it feels that the location deserves, but, in return for such agreement, the tenant might negotiate for a higher breakpoint.
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. Also, in order to maximize the potential percentage rent payable to the landlord, the landlord should attempt to require that the tenant 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.
Scott C. Butler is a principal in the Real Estate, Business & Finance group at Kaplin Stewart in Blue Bell, PA.