Percentage rent allows a retail landlord to benefit from a tenant’s success. In addition to the base rent, tenants will pay an additional rent based on some percentage of the tenant’s gross sales typically triggered by what is termed a “breakpoint”. New tenants asked to pay percentage rent are typically troubled by the idea mostly because they see it as a way of being penalized for success. Clearly, landlords benefit significantly from percentage rent reaping additional profits in times of economic boom while losing nothing during downturns. However, there is a synergistic effect that can benefit tenants. Most landlords aggressively seek to maximize profits and creating the right tenant mix and shopping center atmosphere aids in increasing the revenue stream for all tenants thereby increasing the landlords rent. In such cases, the landlord at least arguably is creating something of value for tenants. The value of a landlord’s labors in this scenario is of course difficult to measure, but with an earnest effort it can unquestionably have a dramatic impact on shopping center sales.
Percentage rent is typically set at five percent (5%) of gross revenue but usually doesn’t trigger until some “breakpoint”. The breakpoint can be arbitrarily set by the parties as a stipulated breakpoint (for instance at $1,000,000). In this case, a tenant would be obligated to pay 5% of all gross sales in excess of $1,000,000. If gross sales were $1,500,000, the tenant would owe as additional rent of $25,000 (5% of $500,000). Many retail leases set the breakpoint at what is termed the “natural breakpoint”. For the natural breakpoint, you divide the base rent by the set percentage (the typical 5%). The natural breakpoint results in a percentage rent applicable to sales over and above the point in which the base rent would equal 5% of gross revenue. In other words, the tenant is paying 5% of gross sales or the base rent whichever is higher. If the breakpoint is not reached, the base rent is higher than 5% of gross sales. If the base rent in the above example was $120,000 ($10,000 a month), the breakpoint would be $2,400,000 resulting in no additional rent due. The landlord is then guaranteed a minimum rent no matter how bad sales are, but benefits when sales are good. Tenants benefit if the stipulated breakpoint is above the natural breakpoint but not if it is below the natural breakpoint. In the above example, if the stipulated breakpoint is $4,000,000, the additional rent would be zero. If the stipulated breakpoint is $500,000, the tenant would pay the base rent ($120,000) plus a percentage rent of $50,000 (5% of $1,000,000).
This may all seem a bit complicated. However, the simplest way to view percentage rent is as follows: a breakpoint below the natural breakpoint is worse for tenants and better for landlords and a breakpoint above the natural breakpoint is better for tenants and worse for landlords. Ultimately, determination of the breakpoint will depend on the parties relative bargaining positions. In fact, nationally recognized anchor tenants may demand a rent on a pure percentage of sales.
In addition to determining the breakpoint, it’s important to precisely define how gross sales are determined. Landlords typically seek a broad definition including the actual sales price of all goods and services whether delivered or licensed by the tenant, subtenants or any third party concessionaires. Tenants seek to exclude things like sales taxes, proceeds from gift certificate sales until said gift certificates are redeemed, credits and refunds, sums received for lost or damaged merchandise, sales of assets not made in the ordinary course of business, sales to employees at a discount and incidental receipts from things like stamp machines or the sale of money orders. The list of potential exclusions is limitless. The important thing to remember is that the parties should clearly define gross sales so that there is no confusion down the road.
Finally, percentage rent clauses should clearly set forth the tenant’s record keeping requirements so that a reliable calculation of gross sales can be made and when and how often payment of percentage rent is due (monthly, quarterly or yearly).
For more information on percentage rent in commercial leasing, contact your local San Diego commercial lease attorney today.