The Economics of Percentage Rent in Retail Leases
In the shifting landscape of commercial retail, the rigid "fixed rent" model is not always the most efficient structure for landlords or tenants. Whether driven by economic volatility, unproven retail concepts, or a desire for aligned incentives, percentage rent has remained a vital tool in the commercial leasing attorney’s drafting arsenal.
While percentage rent clauses create a financial partnership that can benefit both parties, they also introduce significant complexity regarding accounting, enforcement, and definition. This article outlines the economic theory behind percentage rent and the critical legal considerations for both property owners and retail tenants.
How Percentage Rent Operates
In a percentage rent structure, the tenant typically pays a reduced "Base Rent" (or Minimum Rent) combined with "Overage Rent", a percentage of the tenant's gross sales.
The trigger for this additional payment is known as the Breakpoint.
The Natural Breakpoint: This is the most standard mathematical approach. It is the point at which the percentage rent amount equals the base rent. It is calculated by dividing the Annual Base Rent by the agreed-upon Percentage Rate.
Example: If Base Rent is $100,000 and the Percentage Rate is 5%, the tenant pays overage only after sales exceed $2,000,000.
The Artificial Breakpoint: A negotiated dollar amount unrelated to the base rent math. Tenants with strong leverage may negotiate a higher artificial breakpoint to delay the onset of overage payments.
Risk Allocation
From an economic perspective, percentage rent functions as a risk-sharing mechanism, solving the "Principal-Agent" problem inherent in leasing.
Alignment of Interests: In a triple-net or gross lease, a landlord has little immediate financial incentive to drive foot traffic once the lease is signed. In a percentage rent lease, the landlord becomes a stakeholder in the tenant’s success, encouraging better property maintenance and tenant mix curation.
Inflation Hedging: For landlords, percentage rent provides a natural hedge against inflation. As the price of goods rises, gross sales volume generally increases, lifting rental income without the need for complex CPI adjustment clauses.
Downside Protection: For tenants, the lower base rent reduces fixed overhead, providing a safety net during economic downturns or seasonal slumps.
Pros and Cons
For the Landlord
Pros:
Upside Potential: The landlord captures value from "unicorn" tenants whose sales far exceed market expectations.
Performance Data: The requirement for sales reporting provides the landlord with valuable data on the health of the shopping center.
Tenant Viability: Lower fixed costs reduce the likelihood of tenant default during lean months.
Cons:
Financing Challenges: Lenders often discount percentage rent when underwriting loans, preferring guaranteed base rent.
Administrative Burden: The landlord must dedicate resources to collecting sales reports, reconciling payments, and conducting audits.
For the Tenant
Pros:
Lower Barrier to Entry: Reduced base rent lowers the break-even point for new locations.
Sustainable Cash Flow: Rent obligations scale down proportionally with revenue drops (e.g., during a recession).
Cons:
Privacy Intrusion: The tenant must share sensitive financial data and subjects their books to landlord audits.
Profit Erosion: In high-volume years, the total rent paid (Base + Overage) may significantly exceed fair market value for the space.
Defining "Gross Sales"
For legal counsel, the definition of "Gross Sales" is the primary battleground. A loosely drafted definition can cost a tenant thousands in rent on revenue that generated no profit. Conversely, a restrictive definition can allow a tenant to hide revenue from the landlord.
Tenants should aggressively negotiate to exclude the following from Gross Sales:
Returned Merchandise: Refunds and allowances to customers.
Internet Sales: Specifically, sales where the transaction occurs online, even if the goods are shipped from the store. Note: "BOPIS" (Buy Online, Pick Up In Store) is a frequent point of contention.
Employee Sales: Merchandise sold to staff at a discount/cost.
Taxes: Sales, excise, and luxury taxes collected for the government.
Gift Cards: Revenue should only be recognized upon redemption at that specific location, not upon the sale of the card.
Casual Sales: Sales of fixtures, machinery, or equipment not part of the standard inventory.
Drafting Pitfalls - Radius Restrictions and Audits
Two ancillary clauses often create litigation risks in percentage rent leases:
The Radius Restriction
To protect percentage rent income, landlords often prohibit tenants from opening a competing store within a certain radius (e.g., 3 miles). If a tenant violates this, the landlord may seek to include the sales from the second location in the gross sales calculation of the first location. Tenants must ensure these restrictions do not inadvertently ban them from opening necessary satellite locations or fulfillment centers.
The Audit Clause
Landlords must retain the right to audit the tenant's books to verify gross sales. The landlord pays for the audit. However, if the audit reveals an underpayment of rent exceeding a certain percentage (typically 3–5%), the cost of the audit shifts to the tenant, along with interest on the unpaid rent.
Conclusion
Percentage rent leases offer a flexible, economically sound alternative to fixed-rent structures, particularly in uncertain markets. However, they require precise drafting. A well-constructed lease aligns incentives and shares risk; a poorly drafted one leads to audit disputes and eroded profits.
Whether you are a property owner seeking to maximize asset value or a retailer expanding your footprint, our Real Estate Practice Group can assist in structuring leases that protect your bottom line.