By Chris Cobb | Associate
If you are a current or prospective retail tenant, then you need to know the ins and outs of commercial lease percentage rent in your lease. In the following paragraphs, I will demystify the commercial lease percentage rent clause which requires tenants to pay a percentage of gross sales in addition to their base rent. There are some terms that may seem convoluted and scary. But fear not, knowledge is power!
Commercial lease percentage rent clauses can be found when leasing a wide variety of commercial spaces such as shopping malls, multi-tenant retail spaces, and stand-alone retail buildings. The methodology behind percentage rent goes like this: The shopping center is a natural draw for customers who will tend to walk among the various shops. The landlord creates value for each tenant by selecting a wide variety of businesses that are placed in proximity to each other. For example, a coffee shop, a lunch or deli spot, and a wireless service provider may share a common area. Because of the foot traffic created by the shared space, these individual businesses see increased activity and revenue.
The Math Breakdown
The best way to see how commercial lease percentage rent works is to use an example with numbers. Let’s run through a high-level example with natural breakpoint and artificial breakpoint. Imagine you see the perfect retail space sandwiched between a Starbucks and a Verizon Wireless store. It is 2,000 SF with base rent of $30 per SF. This means you will pay $60,000 annual and $5,000 per month in base rent. Let’s assume the landlord wants to implement 5% of the gross sales in a percentage rent clause using a natural breakpoint. The natural breakpoint is calculated by taking the annual base rent and dividing it by the percent that the landlord wants to claim. In this case: $60,000/0.05, which equals $1,200,000. What does this mean? The tenant is required to pay the landlord 5 pennies for every dollar in annual gross sales the business makes over $1,200,000, . If the business makes $1,400,000, then the tenant must pay the landlord $10,000. The math can be seen here as ($1,400,000 – $1,200,000) x 5% = $10,000.
Let’s look at the logic behind this structure. The tenant should only pay the percentage rent on sales over and above what is required to pay the minimum rent. In this case, the landlord desires 5% of $1,200,000 in gross sales. This would equal the minimum rent payment of $60,000. Here it makes sense that the percentage rent requirement would only kick in after this minimum rent breakpoint is achieved. Artificial breakpoint is similar to natural breakpoint in every way except one. With artificial breakpoint, the dollar amount is pre-negotiated between the landlord and the tenant. If we use the example above, the landlord may require a percentage rent to be paid on all sales above $1,000,000 (instead of the natural breakpoint of $1,200,000).
As with many things, the terms of the percentage clause may be negotiable. In some cases, a tenant may wish to have a higher minimum rent with a higher breakpoint. This allows them to profit at lower gross sales numbers before percentage rent comes into effect. This would primarily apply to a new business or a business that has significant upfront costs of capital, marketing, etc.
In addition, tenants should exercise diligence in understanding the types of revenue that are included or excluded from the commercial lease percentage rent clause. For example, returned items and employee sales may not be counted toward the total gross sales. Furthermore, in today’s intensely evolving retail environment, the avenue of internet sales is becoming increasingly important. Because of this, landlords may insist that sales conducted via the web be included. Particularly if the distribution is taking place on the premises. Landlords may also require tenants to allow audits of their gross sales or provide regular gross sales reports. Minimum operation hour requirements or making quarterly payments of percentage rent may also be required. Tenants may also be asked not open additional locations within a specified radius or market.
It’s important to be aware of the components of any lease. Educating yourself and relying on an expert to assist you can help guide you in the right direction. Shared retail space certainly has its advantages. However, it may involve doing a bit more research. I hope that this simple break-down will serve as a beginning to a greater understanding of a commercial lease percentage rent clause. If you encounter or anticipate encountering such a clause, let’s have a chat.