How Does a Percentage Lease Work?

A percentage lease is a rental agreement where the tenant pays a base rent plus a percentage of their revenue and is typically used in commercial real estate, especially in retail environments such as shopping centers. These variable rent agreements are useful for tenants' businesses but also have downsides. Read on to find out how percentage leases work.

How a percentage lease works

A percentage lease is one type of commercial lease agreement. The tenant pays a base rent plus a percentage of their gross monthly sales. The annual minimum base rent is typically lower than in a standard lease, thus reducing initial costs for the retail tenant. The property owner gets higher rental income when the tenant's business performs well, aligning the success of both parties.

Percentage leases are especially useful for tenants whose businesses thrive on foot traffic, such as clothing stores, restaurants, and specialty shops. They encourage the property owner to support a commercial tenant because their rental income correlates with the tenant's gross revenues. It's a mutual agreement in which both parties have a vested interest.

The components of a percentage lease arrangement

A percentage lease agreement has several components:

• Base rent: Base rent refers to the fixed minimum amount paid by the commercial tenant regardless of the tenant's sales revenue. It is typically levied per square foot of floor space.
• Percentage rent: Beyond the per square foot cost, percentage rent is additional rent paid based on an agreed upon percentage of the tenant's monthly or annual gross sales beyond the break even point. This flat percentage amount is over and above the fixed base rent. Agreed upon percentage rate figures average around 6%, but a higher percentage is possible.
• Break even point: Also known as the breakpoint, the break even point specifies the gross sales threshold beyond which the tenant pays percentage rent on top of their square foot fixed monthly rent. Agreements commonly use a natural breakpoint (base rent/percentage rate) or an artificial agreed-upon gross revenue figure. A high break even point means you'll pay less for the same gross sales. A lower break even point means paying more percentage rent but typically invites a lower base rent.
• Excess gross sales: Gross sales that exceed the breakpoint. This helps to calculate the percentage rent.

Calculating a percentage lease

A typical percentage lease formula looks like this: Total rent = Base rent + (Percentage rate x Excess gross sales)

Here's an example:

1. Let's say the base rent is $4,000 per month based on rented space ($48,000 per year). The agreed upon percentage lease uses a 7% rate to calculate percentage rent.
2. To work out the total rent, we need to calculate excess gross sales. To do that, we must calculate the break even point. The lease uses a natural break even point, which is calculated using: Base rent ($48,000) / Percentage rate (7%) = $685,714
3. Any revenue beyond this break even point is considered excess gross sales, and the tenant pays a percentage rent on that. If total annual sales are $1,000,000, that means excess gross sales are: $1,000,000 - $685,714 = $314,286

Now we have all we need to calculate the total rent:

1. $48,000 + (7% x $314,286)
2. $48,000 + ($22,000)
3. Total rent = $70,000

Pros and cons of percentage leases

Percentage leases have plenty of pros and cons for both landlords and tenants. Here are some upsides and downsides to consider.

Pros

• Aligned interests: The landlords and tenants share a common goal of additional sales, fostering a supportive business partnership.
• Reduced risk for tenants: Percentage rent decreases during slower sales periods, reducing the fixed cost and aligning with their business's cash flow.
• Incentive-based structure: The arrangement motivates the property owner to maintain and improve their properties to boost their revenues from successful tenants.

Cons

• Complex lease terms: Percentage leases are more complicated to negotiate and administer than a gross lease or net lease.
• Increased monitoring: Requires keeping track of tenants' sales.
• Economic sensitivity: Rental income is more susceptible to economic downturns, affecting the tenant’s sales and consequently the landlord's revenue.

Is a lease based on percentage rent right for your business?

Here are some tips to help determine if a percentage lease is right for you as a tenant:

Understand your sales volatility

It's important to consider how much sales you expect throughout the year. A percentage lease is advantageous if sales figures vary seasonally, reducing your percentage rent.

Evaluate the location

A percentage lease is suitable for prime locations because it offers lower base rent than in a gross or net lease for the same property, making it more accessible. However, it's important to analyze your agreed upon base rent and predicted revenues to ensure you don't pay more rent than you would under other commercial leases.

Create a long-term forecast

A comprehensive financial forecast is crucial when considering a percentage lease. Anticipating various sales outcomes enables you to gauge how lease terms might impact your finances over time.

While a percentage lease can initially lower costs, if your business projections show significant growth, this arrangement will elevate percentage rent payments as your sales increase. This can affect your overall profitability, so evaluate if the potential increased cost aligns with your long-term financial strategy and growth expectations.

Examine market trends

Staying abreast of current and anticipated market trends is essential. Variable percentage rent could pose financial risks in regions where consumer spending or foot traffic is dwindling.

Get legal advice

Consult with a legal expert familiar with commercial real estate before you commit to a percentage lease. They will help you understand the nuances of the arrangement—such as how to balance base rent and percentage rent—and advocate for the best contractual agreement.

How to craft a percentage lease agreement with your real estate attorney

Your real estate attorney plays a crucial role in a percentage lease, ensuring the contract aligns with your business goals. Your attorney's overarching goal is to safeguard your interests by ensuring the lease terms are transparent, equitable, and conducive to your business's financial health.

Understanding your needs

Your real estate attorney uses your specific financial limits and long-term objectives to negotiate the most favorable terms, potentially including reduced base rent or modified percentage rate calculations.

Negotiating key terms

A legal expert will focus on key terms such as securing a lower base rent and agreeing to the rate for the percentage rent calculations. They will help you to set a lower break even point or a higher break even point depending on your goals.

Ensuring clarity and compliance

Your attorney will explain the terms and conditions in your commercial real estate rental contract. They will draft the terms to follow local, state, and federal laws. Their attention to detail will minimize the likelihood of future misunderstandings or legal disputes.

Review and preparation

Work with your attorney to pinpoint any clauses that might be disadvantageous or excessively demanding. They will protect your interests by preparing counter-proposals.

Final review and modifications

A thorough review of the final lease draft is a vital part of your real estate attorney's job, ensuring that all terms discussed during negotiations are accurately reflected.

Signing and execution

After final review, your attorney will supervise the signing process to satisfy all legal formalities, securing a legally binding contract.

FAQs

How does the breakpoint influence a percentage lease?

The breakpoint sets the sales threshold above which a tenant must pay percentage rent beyond their initial base rent. The natural breakpoint is the annual base rent divided by the negotiated percentage of sales. Once sales exceed this breakpoint, the tenant pays additional percentage rent. An equitable break even point aligns the interests of both landlords and tenants.

What happens if a tenant's sales do not exceed the breakpoint?

A tenant whose gross revenue doesn't exceed the break even point only pays the fixed base rent agreed upon in the percentage lease. This structure benefits tenants by providing a predictable minimum rent cost during lower sales periods, reducing financial pressure and aligning rental expenses more closely with their revenue performance.

How are percentage rents reported and audited?

Percentage rent is typically paid quarterly or yearly to the property owner, but the tenant will periodically report their monthly sales to the landlord. Landlords can audit the tenant sales reports themselves or hire professional commercial lease auditing services. Auditors may use a variety of methods, like cross-checking the sales data provided to verify sales reports when calculating percentage rent.

What are the tax implications of percentage leases?

Tenants can typically deduct both base and percentage rent payments as a business expense, potentially reducing taxable income. However, it's important for landlords and tenants to reach a mutual agreement on sales.

Retail tenants should keep thorough records of sales data and corresponding rent payments, as varying monthly business revenues will influence the amount of rent declared, and these figures will be audited under a commercial lease agreement. There are no implications for property taxes.