Commercial real estate leases have evolved and expanded to meet the growing needs of both tenants and landlords. If, for nothing else, the number of leases that may be executed upon is as varied as the clientele they may serve. However, of all the leases made available to tenants and landlords, few are as underappreciated as the percentage lease. Otherwise known as percentage rent, a percentage lease aims to grant both tenants and landlords more optionality in how financial exchanges are made.
A percentage lease is another tool that facilitates rental agreements, which begs the question: What is a percentage lease? The following is designed to explain what a percentage lease is, how it works, and how each party may use it to their advantage.
What Is a Percentage Lease?
A percentage lease is an agreement between lessors and lessees in the commercial real estate sector. Not unlike traditional leases, percentage leases will require their tenants to pay a base rent each and every month. Aptly named, however, percentage leases will also require commercial tenants to pay a percentage of their gross revenue to the landlord as well. In exchange for acquiring a percentage of any revenue earned while doing business on the rental premises, landlords will typically decrease the base rent price. As a result, tenants will almost always see lower base rents when they agree to a percentage lease. Consequently, tenants will increase monthly rental payments relative to their revenues.
How A Percentage Works In Commercial Real Estate
Due to their specific structure, percentage leases are almost exclusively reserved for catering to retail tenants. In fact, percentage leases are most commonly executed in multi-tenant retail spaces like malls. The nature of malls enables both sides of a percentage lease agreement to benefit in ways other leases can’t promise.
On the surface, taking a percentage of a tenant’s revenue sounds unfair, and after all, it’s the tenant working hard to generate revenues in the first place. However, signing a percentage lease may also coincide with significant advantages, many of which may justify the added cost.
In particular, some tenants may be ready and willing to offer a percentage of their gross revenue in exchange for a heavily trafficked storefront in a popular mall. A percentage lease can cater to both sides of the agreement in the right situation. While the landlord is entitled to a percentage of the tenant’s gross revenues, the tenant may see their business increase exponentially from being in a mall and being located next to similar retail spaces.
To be clear, percentage leases do not take a percentage of tenants’ entire sales. Instead, underwriting on percentage leases tends to dictate a threshold that must be met to collect the revenue. More specifically, tenants will only be expected to pay a percentage of their gross revenue when they meet or exceed the sales amount agreed upon in the lease itself.
Let’s say, for example, a percentage lease specifically dictates that a tenant must pay a certain percentage of their revenue over a $25,000 threshold. If the tenant fails to meet the minimum sales requirement, they may not be required to pay any of their revenues to the landlord at all. However, the tenant will be expected to pay a set percentage on every dollar that exceeds the $25,000 threshold.
Of course, not all percentage leases are created equal. The underwriting on percentage leases can vary dramatically, and needs to be accounted for. While some are designed to take advantage of tenants, others are completely fair. As a result, it’s in the best interest of both landlords and tenants to familiarize themselves with the following, before agreeing to a percentage lease:
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Not unlike most traditional leases, percentage leases will come complete with a base rent price. Aptly named, the base rent represents the minimum amount a tenant will be required to pay each month to continue operating in the leased real estate. While there are several factors that go into determining the base rent, tenants will typically pay “the going rate” per square foot for a given location. However, it is important to note that the base rent price in a percentage please will typically be discounted. The landlord will often ask for a smaller base rent in exchange for a percentage of the tenant’s gross revenue.
The break-even point, also known as the breakpoint, is the minimum threshold we spoke of earlier. Specifically, the break-even point is the agreed-upon amount the tenant must meet or exceed before they start paying a percentage of their gross revenue to the landlord. While the break-even point will vary from lease to lease, it’s often identified as the point at which the percentage rent equals the base rent.
To calculate the break-even point, divide the base rent by the percentage the landlord intends to charge. For example, if a tenant is expected to pay $4,000 a month in base rent and the landlord has underwritten a percentage lease requesting 7.0% of all gross revenue that exceeds the threshold, the break-even point is $57,142 (4,000/0.07). In this scenario, a tenant paying $4,000 a month in base rent will need to pay an additional 7.0% of all their gross revenue that exceeds $57,142.
The percentage rent is the amount the landlord will charge on any gross revenue that exceeds the break-even point. More often than not, the percentage rent is a flat rate. The percentage rent is entirely dependent on the landlord and the specific real estate relative to the lease. As a result, percentage rates will typically increase with the quality of the property. That said, it has become commonplace for percentage leases to include a rate somewhere in the neighborhood of 7.0%. Again, the rate can change depending on the property itself, but 7.0% has become the closest thing to an industry average that we have.
Negotiating A Percentage Lease As The Tenant
While there may not be a lot of room for negotiations, tenants do have the ability to influence percentage lease underwriting. Due to the nature of most percentage lease agreements, however, tenants shouldn’t expect to have a lot of leverage. Nonetheless, it’s within a tenant’s rights to negotiate everything from the base rent to the break-even point. As a tenant, businesses will aim to negotiate a lower base rent and a higher break-even point.
Negotiating A Percentage Lease As The Landlord
With the majority of percentage leases taking place in malls and shopping centers, most of the underwriting is similar. In other words, operating in a multi-tenant building will require most of the percentage leases to obey an industry standard. Still, that doesn’t mean landlords won’t try to negotiate terms that lean in their favor. Most landlords will look to increase the base rent, while simultaneously lowering the break-even point.
The adapting financial needs of independent commercial businesses have led to increasingly more ways to facilitate lease agreements. Of the many lease options granted to businesses, however, few have the potential to benefit both sides of an arrangement more so than a percentage lease. When used correctly, a percentage lease can benefit both landlords and tenants. That said, lease agreements can get convoluted and confusing to those who don’t understand them, leading to unfavorable circumstances. As a result, we created this guide to help everyone involved in a respective percentage lease get the most out of a deal.
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