A Primer on Percentage Rent
March 26, 2001
Stephen W. Snively- Orlando
"Prithee, tell him, so much the rent of land comes to: he will not believe a fool" King Lear, Act I Scene 4
Percentage-rent is based on the gross sales of
a tenant at a particular store. It is commonplace to the retail industry
where tenant revenues are based on sales, rather than services. A
formula is established in the lease to determine the amount of percentage
rent. Elements included in the formula are gross sales, a
“breakpoint” and a percentage rate. Typically, percentage rent is
calculated and paid annually.
Historical Origins
The concept of percentage rent originated in
the Depression era, after many retailers were forced into bankruptcy by fixed
monthly rent obligations. National chain stores, such as W.T. Grant
Company, with economic leverage and an appetite for long-term leases, began to
negotiate leases which provided for no minimum rent, but percentage rent
equivalent to 1% of gross sales. Since then, the percentage rent clause
has evolved into another tool to balance the economic positions of landlord
and tenant. From the perspective of a landlord, percentage rent is a
hedge against inflation and way to share in the long-term prosperity of a
successful tenant. From the perspective of the tenant, percentage rent
is a way to reduce costs during rough economic times.
In the years following the Depression,
percentage-rent provisions were used in retail leases for properties with
prime downtown locations as a mechanism for the landlord to share in the
success of the location, which explains why percentage rent often is not paid
for poorer retail locations, where the success of the business is a function
of the merchandise and skills of the tenant. When retail business moved
to shopping centers in the suburbs after World War II, percentage-rent clauses
were widely accepted. From an historical perspective, when a tenant
agrees to pay percentage rent, it acknowledges the right of the landlord to
share in the economic success derived from the store being located
strategically within a market area.
Percentage-Rent Formula
The heart of the percentage-rent formula is
the definition of “gross sales.” A well-drafted shopping center lease
includes receipts of all types. The focus is on revenues arising from
use of the leased premises. The definition of gross sales often
specifically excludes customer refunds, employee discounts, accommodation
sales (stamps, money orders, etc.), coin-operated devices, commissions paid to
third-party credit card companies, merchandise exchanged between stores,
returns to manufacturers and sales taxes collected.
The traditional method to calculate percentage
rent is to take a percentage of gross sales and deduct annual, fixed-minimum
rent. Tenants sometimes want other expenses which increase (e.g.
ad valorem real estate taxes) deducted from percentage rent. The
breakpoint method to calculate percentage rent takes a percentage of gross
sales in excess of a stated dollar amount, or “breakpoint.”
Natural Breakpoint
A “natural” breakpoint is the volume of
gross sales a tenant must generate to pay the fixed minimum rent, at a rate
equal to percentage to be used for percentage-rent calculations. It is
calculated by dividing the fixed minimum rent by the percentage used for
percentage-rent calculations. For instance, if the fixed rent is
$140,000 per year, and the percentage for percentage rent purposes is seven
percent, then the natural breakpoint would be $2,000,000. The underlying
rationale of a natural breakpoint is that if it is agreed that the landlord
gets seven percent of gross sales, it should not receive a percentage of gross
sales necessary to generate sufficient revenues (i.e. $2,000,000) for
the tenant to pay the minimum rent ($140,000). If the percentage is
lower, the natural breakpoint will be higher. Use of a natural
breakpoint would result in the same percentage rent as the traditional method
described above.
Artificial Breakpoint
Use of an “artificial” breakpoint can
change the result. With the artificial breakpoint method, fixed-minimum
rent and percentage rent can be set independently. For instance, a
landlord might agree to reduce fixed-minimum rent if a tenant agrees to
increase percentage-rent with a higher artificial breakpoint. A
high-volume tenant with economic strength may argue for more minimum rent in
exchange for less percentage rent. If the lease term is long, the
landlord may wish to reduce the risks of inflation by greater reliance on
percentage-rent. This will be a function of the respective financial
obligations and expectations of the parties.
Percentage Rate
The final step in calculating percentage rent
is to calculate a percentage of gross sales in excess of the breakpoint.
Different percentage rates are used for different types of stores. The
higher the profit margin on the merchandise, the higher the percentage
figures. For instance, the percentage used to calculate percentage rent
typically is lower for a supermarket (higher volume and lower profit margin)
than it would be for a jewelry store (lower volume and higher profit margin).
Percentage-rent provisions are accompanied
customarily by a requirement that the tenant maintain contemporaneous records
of sales, submit periodic sales reports, allow the landlord to audit books of
the tenant, sell a specific type of merchandise, establish minimum hours of
operation, and not compete. Continuous-operations clauses, which
prohibit a tenant from “going dark,” may also be included.
Typically, a non-competition provision prohibits the tenant from opening
additional stores within a stated radius of the shopping center. The
non-competition clause is intended to prevent the dilution of sales that would
result from an additional store within the same market area. A common
remedy for violation of such non-competition clauses is to include the sales
from any additional stores in the market area in the gross sales of the store
for percentage-rent purposes. Portions of this article appeared previously in
an article entitled “KillPercentageRent.com: Internet Sales and
Shopping Center Leases,” Probate & Property, July/August 2000, and are
reprinted with permission of the American Bar Association.
Mr. Snively is a Partner in our Orlando
office. He can be reached at 407-244-1112 or at ssnively@hklaw.com