What Is a Percentage Lease?

A percentage lease links part of your rent to how well your location sells. It is used mainly in retail, particularly shopping centers and other multi-tenant retail properties. The logic for the landlord is that a well-run center helps its tenants sell more, and the landlord wants to share in that gain. For a tenant, part of the rent is linked to performance, which can make a location easier to take on.

Three negotiated numbers do most of the work.

• Minimum base rent: the fixed rent you owe whatever your sales are.
• Percentage rate: the share of qualifying sales you pay as percentage rent, also called overage rent.
• Breakpoint: the level of sales above which percentage rent starts.

The formula, as Altus Group presents it, is the percentage rate multiplied by gross sales above the breakpoint. Below the breakpoint, you owe only the base rent. A less common variation has no base rent at all, with percentage rent on all sales. Tango Analytics notes that this model carries more risk for landlords.

A breakpoint can be set in one of two ways, and the difference changes what you pay.

• Natural breakpoint. This is base rent divided by the percentage rate. It is the sales level at which the percentage, applied to total sales, would exactly equal your base rent.
• Artificial breakpoint. This is a dollar amount of sales the parties simply agree on, without using the formula. It can be set above or below the natural figure.

The natural breakpoint has an elegant logic, since base rent can be viewed as the percentage you have already paid on sales up to that level. Tango Analytics summarizes the effect of an artificial breakpoint: one above the natural figure favors the tenant, and one below favors the landlord.

If base rent is scheduled to rise, ask what happens to the breakpoint. A natural breakpoint moves with the rent, and a fixed artificial one may not.

The numbers below are hypothetical, for illustration, and do not reflect market rates. A store has base rent of $60,000 a year and a percentage rate of 5 percent.

1. Find the natural breakpoint. $60,000 divided by 5 percent is $1,200,000 in sales.
2. Suppose sales are $1,000,000. That is below the breakpoint, so percentage rent is zero. Total rent: $60,000.
3. Suppose sales are $1,500,000. Sales above the breakpoint are $300,000. Five percent of that is $15,000. Total rent: $75,000.
4. Now apply an artificial breakpoint of $1,400,000 to the same sales. Sales above it are $100,000, percentage rent is $5,000 and total rent is $65,000.
5. Finally, apply an artificial breakpoint of $1,000,000. Sales above it are $500,000, percentage rent is $25,000 and total rent is $85,000.

The same store with the same sales pays $65,000, $75,000 or $85,000, depending only on where the breakpoint sits. That is why the breakpoint deserves as much attention as the percentage. Also keep in mind that base rent and percentage are linked. A landlord may offer a lower base rent in exchange for a lower breakpoint or a higher rate, and you should model each combination at the sales levels you actually expect.

Percentage rent is applied to a defined figure, usually gross sales, and the definition is one of the most consequential parts of the clause. A.Y. Strauss lists refunds and sales to employees among the exclusions both sides usually accept, and tenants should confirm the definitions. Tango Analytics adds that modern leases often pull curbside pickup, buy-online-pick-up-in-store and local delivery into a location’s gross sales.

Consider each of these questions for your own business.

• ✓Are returns, refunds and exchanges deducted from gross sales?
• ✓Are sales taxes collected from customers excluded?
• ✓Are employee discounts and employee sales excluded?
• ✓How are gift cards treated: when sold or when redeemed?
• ✓Are online orders counted if they are placed elsewhere and picked up here, or placed here and shipped from elsewhere?
• ✓Are delivery service fees, catering, vending or third-party commissions counted?
• ✓Are credit card fees or bad debts deductible?
• ✓Is the rate the same for all product lines, or do low-margin items carry a lower percentage?

A percentage rent clause is rarely alone. Because the landlord’s income now depends on your sales, it will usually want other protections, and these are often as important as the rent itself. Altus Group mentions sales reporting, audits and limits on nearby locations, and continuous operation clauses appear in many retail leases as well.

• Sales reporting. You submit regular sales reports, so your systems need to produce them in the required form.
• Audit rights. The landlord can examine your sales records. Read how long you must keep them, and who pays if a discrepancy is found.
• Radius restrictions. You may be barred from opening another location nearby, since a new store could divert sales. Look carefully at how this limits your expansion plans.
• Continuous operation. You may be required to stay open during set hours, which reduces your flexibility if a location underperforms.

Before you agree to these, think about what they mean for the way you run the business. A restriction on a second nearby location can cost more over time than the percentage rent ever would.

Altus Group frames the basic tension: owners generally prefer a high minimum rent, a low breakpoint and a high rate, and tenants generally prefer the reverse. Common tenant requests include these.

• A breakpoint at or above the natural figure, and one that accounts for planned base rent increases.
• A clear definition of gross sales, with the exclusions listed.
• A narrower radius restriction, with a shorter duration.
• Relief from continuous operation requirements during renovations or events outside your control.
• For a new business with slow early sales, a low base rent in the early years, or a structure that gives you time to build volume before overage applies.
• Annual, not monthly, calculation of percentage rent, so a strong season does not trigger overage in a year that ends below the breakpoint.

At Tenant Advisory Group we represent tenants, and on a retail deal with percentage rent we model the proposal at low, expected and high sales levels, so an owner can see the rent at each level before agreeing. Have your attorney review the sales definition and audit clause. Your CPA should confirm your point-of-sale system can produce the required reports.