A Primer on Percentage Rent
"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.
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.
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.”
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.
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.
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 email@example.com