Percentage rents (occasionally called overage) are another way for landlords to collect money from tenants who lease retail space. Not every landlord will require that tenants pay percentage rent. It really depends the commercial real estate market you are in, the location of the retail shopping center in your city, and the landlords preference. Minimum rents are estimated by the landlord to cover operating costs, ground rents if any, and debt service on loans. Percentage rents create the landlord’s profit potential as the property matures and draws more sales volume.
In effect, the landlord is saying that it has spent a lot of time, money, and effort putting together a shopping complex that will attract customers. If, as a result of creating this shopping environment, the tenant does well enough to exceed reasonably profitable sales goals, the landlord should share in the good fortune that it played a part in creating.
Some tenants, banks for example, escape percentage rents because they draw considerable traffic to the center. Also, second story space is usually not attractive to retailers (due to presumably reduced foot traffic-except in malls) and it is often converted to office use, thereby skirting percentage rent. Leases for these tenants will normally contain periodic rent increases, or be limited to short terms, in order to give the landlord an opportunity to periodically increase rents.
Tenants Position on Percentage Rents
While the percentage retail lease allows the tenant to minimize the base rent, the tenant is not guaranteed a profit just because rent is based on sales. Successful retailers know the numbers of their business. To ensure the success of the business, it behooves both the tenant and the landlord to keep the actual percentage of sales within a comfortable range of profitability, projected on the basis of sales dollars per square foot. Restaurants for example generally cannot operate profitably with rents above 8 to 10 percent of gross sales. A variety of publications list commonly used percentages for various types of businesses, or the tenant may consult a commercial real estate broker or appraiser. Astute landlords will be skeptical of tenants willing to pay above average rents.
In many cases however tenants do not object to percentage rents under the theory that they will be doing sufficient volume to be making plenty of money. Under those conditions they will share some percentage of the gross with the landlord. As a general principle, tenants can make enough profit to justify operating a store without ever reaching percentage rent. If they do reach a level of gross sales sufficient to pay percentage rent, they have not objecting to parting with some of it in favor of the landlord.
Types of Percentage Rent Retail Leases
Percentage rents may be computed on “gross sales” or on “net profits”. Because of the problems, and let’s face it, the abuses that can crop up in computing “profit,” most leases are based on the tenant’s “easier to determine” sales.
- “No Minimum; percentage only” – Very large retail chain stores will not readily agree to a minimum rent for a new and unproven location. They obligate the landlord to share the risk of developing the property’s desirability by agreeing to pay a percentage only. Smaller retailers might get away with this type of lease on a secondary site, or in an extremely overbuilt market. The landlord must be careful that such deals do not impede financing, since lenders typically consider minimum rents as their security when underwriting a loan.
- “Percentage against a minimum” – This method provides the landlord minimum rent for the coverage of operating expenses, loan payments, and ground rent, while still creating upside potential from percentage rent. It also allows the possibility for escalating the minimum rent annually as operating costs increase, or as mortgage or ground lease payments escalate. This is probably the most commonly used method.
- “Minimum plus percentage” – The percentage can be based on the total sales volume, or on sales in excess of a stated amount. The minimum rent can be fixed for the lease term, graduated periodically throughout the term, or conditioned on the tenant achieving specified sales volumes. Obviously, the exact combination must be negotiated. Only the most energetic landlord’s use this type of lease.
Sometimes tenants try to negotiate a “cap” or limit on percentage rents. Needless to say, landlords resist this because it defeats the main purpose of the percentage rent clause………which is to protect the landlord against inflation, and create profit potential by sharing in the increased value of the site.
How Much are Percentage Rents?
Industry standards for percentage rents typically range between 4% and 8% however the percentages will vary depending on the type of operation involved. Low-volume, high-profit operations (furniture, jewelry, liquor) pay high percentages, whereas high-volume, low-markup operations such as discount stores, off-price stores, supermarkets, and giant drugs pay relatively low percentages. The amount of percentage rent to be paid is occasionally a subject of negotiation between a landlord and a tenant, but not often. There are industry standards to which the parties usually will confirm, although these standards are subject to inroads from the largest and best of the tenants in each category, which might be able to bargain for lower percentages.
Retail Gross Sales as the Basis for Percentage Rent
The essential element of percentage rent is gross sales., the sum against which the percentage is applied to arrive at the additional rent that is due, if any. The definition of gross sales should be the subject of careful discussion. The landlord will want all revenue of any type or nature included in the definition. If anything, the landlord will demand that all revenue that could be remotely attributed to this location should be included in gross sales. However, the tenant will want certain specific exclusions, usually related to that portion of the income that is a pass-through (sales taxes, for example) or that is not profit producing. Some exclusions that a tenant should seek
- Sales of fixtures (sales not in the ordinary course of business)
- Returned merchandise
- Interest and carrying charges
- Casualty loss recoveries
- Bulk sales (such as to a succeeding tenant or to a liquidator in a going-out-of-business operation)
- Sales or other taxes
- Negotiating commercial real estate leases
- Receipts from public telephones and vending machines (which would be paying percentage on a percentage)
- Bank card discounts
- Sales to employees at discount
- Revenue from nonprofit operations (such as delivery and alterations)
- Bad Debts
How are Percentage Rents Calculated?
Having established the level of percentage that is applicable to the particular operation in question, it should not be possible to compute percentage rent. Let’s consider a jewelry store operation called Diamonds For You. It has agreed to pay 7% of gross sales as percentage rent. It’s minimum rent on a 5,000 sf space is $5,000 per month, or $60,000 per year. If we take the minimum rent paid by Diamonds for You ($60,000) and, assuming no additional cost offset, divide it by 7%, we get a figure of $857,142. This figure represents what is known as the natural breakpoint, that volume of gross sales that results from dividing the minimum rent by the percentage rent. That is the commercial real estate break-even point.
Now let’s assume Diamonds For You had attained sales of $275 sf or $1,375,000 in gross sales. Multiply this by 7% and the rent due would be $96,250. However, Diamonds for you has already paid $60,000 in minimum annual rent. Thus, $36,250 in percentage rent is due to the landlord.
Another way to come to the same conclusion is to go back to the natural breakpoint, which we had calculated at $857,142. Deducting a natural breakpoint from the actual volume of $1,375,000, we arrive at $517,858 as the amount of gross sales subject to percentage rent. Multiply this gross sales figure by 7% and we end up with $36,250
If a landlord is asking you to pay percentage rent make sure that you understand what that means to your business. Project your annual sales for the next 3-5 years and calculate what you might be required to pay. Percentage rent is a negotiable item when leasing retail space. If you need help just contact our retail space experts or give us a call at 512-861-0525