Percentage rents 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 market you are in, the location of the 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.
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 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
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.
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