A percentage lease is one in which the sales or profits of the leaseholder determine the rent. A base rate, or minimum monthly fee, will typically be required under a conventional percentage lease.
The Base Rent and a Percentage of the Gross or Net Sales, as defined in the Lease Agreement, shall be paid by the leaseholder each month in addition to the Base Rent. What constitutes a “sale” to determine the amount of rent due should be specifically defined in the lease conditions.
Commercial tenants that sign a percentage lease must give the landlord a certain proportion of the gross income they generate from operations at the leased property.
This percentage is added to the base rent, which will be set at a lower amount than it would be under a typical lease to appeal to tenants.
The lease’s % of revenue clause frequently won’t start to operate until a predetermined sales breakpoint has been met.
Understanding Percentage Leases
Base rent (or minimum rent) and a percentage of the monthly or yearly gross sales generated on the property make up a percentage lease. The lessor of a percentage lease benefits from some additional upside beyond what a traditional lease (i.e., no percentage of sales component) could provide. In comparison, the lessee may find this arrangement appealing since it reduces this fixed cost, which often accounts for a significant chunk of operational expenditures. The percentage lease also aligns the interests of the lessor and lessee.
By giving the tenant a desirable location and maintenance services, the lessor strengthens the retailer’s presence to draw more foot traffic and, perhaps, more sales, some of which would be paid to the lessor under the percentage lease agreement.
Percentage Lease Contract Negotiation
Along with the base rent, the landlord and tenant also agree on a “breakpoint,” or the point at which percentage lease payments begin. A landlord would desire a lower breakpoint if it agreed to a lower base rent. The lessee is looking for a low breakpoint and high base rent.
After debating and agreeing on those two numbers, the two parties must decide, among other things, how the sales figure will be excluded (for instance, sales to store employees), how long the store will be open, whether they have the right to change the breakpoint, and how they will audit store sales.
Taking Percentage Leases into Account
Take a look at the financial accounts of Tapestry, Inc., the company that owns the Coach and Kate Spade brands. This company refers to the percentage of its total lease payments that these brands represent as “contingent rentals.”
When “the achievement of the target (i.e., sale levels) is regarded as plausible and estimable,” the corporation records contingent rentals on its income statement. In the 2019 fiscal year, Tapestry paid about 30% of its entire rent as contingent rent (i.e., through a percentage lease). In contrast, the percentage of lease payments for Signet Jewelers Limited was less than 2% of the total rent for the same year.
In addition to a percentage rent clause, a commercial lease agreement will also specify a base rent amount, which is the minimal monthly fee that must be paid in order for the tenant to keep utilizing the premises. This minimum rental fee is often calculated as a fixed cash amount per square foot.
For instance, a restaurant contract might state that the base rate for a 5,000-square-foot space is $10 per square foot. Under such conditions, the business owner would be required to pay $50,000 in rent per year or $4,167 monthly.
Notably, regardless of the tenant’s income, the base rent stipulated in a percentage lease agreement must be paid. It is the minimal revenue the landlord can anticipate receiving from each tenant in this lease scenario.
The Break-Even Threshold
The break-even threshold should be taken into account after base rent. In a typical percentage lease, the landlord won’t begin deducting a portion of the tenant’s income until a predetermined threshold of gross sales has been reached. The break-even point is typically expressed as a financial number and can be described in two ways:
- The tenant and landlord agree on a set number above which a portion of any income will be paid to the landlord as additional rent if the lease agreement employs an artificial break-even point. They might decide, for instance, that percentage rent applies to gross sales exceeding $500,000 in any given year.
- The base rent is split by the agreed-upon portion of income paid to the landlord, resulting in a natural break-even point. Because it guarantees that the break-even point will be higher than the amount of gross sales needed to cover the base rent, many small business owners prefer to adopt a natural break-even point over an artificial one.
The Ratio of the Rent
The percentage rent must also be discussed and agreed upon by both parties. The amount over the break-even point paid to the landlord as additional rent is commonly expressed as a flat percentage. For instance, the landlord and tenant may decide that 6% of any gross sales above the break-even mark are subject to percentage rent.
How to Approach a Percentage Lease Negotiation
You should discuss the lease length and who is in charge of what running costs when negotiating a percentage lease. However, the most frequent factors directly related to the percentage rent provision are listed below.
Being the Tenant
As the lessee, you often look for low base rent and a high break-even threshold. However, since you’ll probably have to select between the two, picking the option with a higher break-even point is frequently more advantageous. This is especially true for young small business owners who can profit at lower gross sales levels before the percentage rent provision kicks in, thanks to a higher break-even point.
You should also discuss the revenue categories subject to percentage rent. For instance, you probably won’t want any sales proceeds from things that were ultimately returned to be included.
Being the Landlord
The minimum rent that landlords seek, however, is often higher, and the break-even point is lower. A lower break-even point and a higher percentage of rent could enhance your overall profits, particularly if your potential tenant has a well-known brand or a loyal clientele. Charging a higher minimum rent will guarantee you steady, consistent revenue.
You should also include lease clauses that permit audits of gross sales and regular sale reports so you can be certain you’re getting the extra rent you’re due.
Is There a Cap on the Amount of Rent the Landlord May Demand?
No, a percentage lease does not have a cap on the rent that the landlord may collect. Rent rises over time in lockstep with rising sales. The only way to set a ceiling or upper limit on the rent the landlord may collect under a percentage lease is to include that information in the lease.
Do I Need a Lawyer for My Commercial Lease?
Commercial leases are extremely intricate contracts with a lot of negotiating room. When negotiating a percentage lease, a real estate attorney may advise you on whether it’s the best option for your company’s needs and defend your interests and rights.