What is Percentage Rent in Retail Leasing and How Does it Work?

Retail real estate has a handful of unique lease concepts that differ from other commercial real estate categories.  One such concept is “Percentage Rent”.  Percentage Rent is a rent payment structure where the tenant pays rent as a percentage of sales in addition to a minimum base rent (“Minimum Base Rent”) or in lieu of a Minimum Base Rent.  The majority of retail leases are structured as “triple net” (“NNN”) leases, where in addition to Minimum Base Rent and/ or Percentage Rent, the tenant pays the landlord it’s pro-rata share of common area maintenance costs (“CAM”), real estate taxes and insurance.  Payment of their net expenses are subject to the terms and conditions of the property and lease between the parties.

Let us break down Percentage Rent in retail leases:

Percentage Rent in Addition to Minimum Base Rent:

Under this rent structure, the landlord and tenant have negotiated a lease to establish the Minimum Base Rent and triple net expenses (CAM, Real Estate Tax and Insurance), however, the parties recognize that the market rent for the space is much greater than the Minimum Base Rent or the tenant has requested additional assistance from the landlord for improvement money to fit-out the space.  There are two (2) formulas to consider, Percentage of Sales over a Natural Break Point or Percentage of Sales over an Artificial Breakpoint.

Percentage of Sales over a Natural Breakpoint

Under this scenario, the Percentage Rent in a letter of intent is written as “In addition to annual Minimum Base Rent, Tenant to pay Landlord “Percentage Rent” equal to six percent (6%) of Gross Sales over the “Natural Breakpoint” at the Property”.  The formula is (Gross Sales – Natural Break Point x % = Percentage Rent).  First you need to establish the “Natural Break Point”.  The Natural Breakpoint is the annual Minimum Base Rent divided by the stated Percentage Rate (6% in this scenario).  For example, if the annual Minimum Base Rent for year one of the lease is $75,000, then the Natural Breakpoint is $1,250,000 ($75,000 / 6% = $1,250,000).  This means that the tenant would then pay landlord six percent (6%) of any Gross Sales over $1,250,000.  If the tenant’s Gross Sales are $3,000,000, then the tenant would pay landlord 6% of $1,750,000 ($3,000,000 (Gross Sales) – $1,250,000 (Natural Breakpoint) = $1,750,000 x 6% = $105,000 (Percentage Rent for Year 1).  In total, the rent tenant would pay landlord in year 1 of the lease would be $180,000 ($75,000 Minimum Base Rent + $105,000 Percentage Rent).

Percentage of Sales over an Artificial Breakpoint

Percentage Rent as a percentage of sales over an artificial breakpoint is a much easier equation.  Under this scenario, the Percentage Rent in a letter of intent is written as “In addition to annual Base Minimum Rent, Tenant to pay Landlord “Percentage Rent” equal to six percent (6%) of Tenant’s Gross Sales over $1,250,000 (the “Artificial Breakpoint”).  The formula is (Gross Sales – Artificial Break Point x % = Percentage Rent).  If tenant’s Gross Sales are $3,000,000, then the tenant would pay landlord 6% of $1,750,000 ($3,000,000 (Gross Sales) – $1,250,000 (Artificial Breakpoint) = $1,750,000 x 6% = $105,000 (Percentage Rent for Year 1).

Percentage Rent as Total Rent:

Percentage Rent as the total rent to be paid by a tenant in lieu of a Base Minimum Rent is a simple equation.  In addition to Percentage Rent, the tenant would also pay landlord triple net costs and expenses (CAM, Real Estate Tax and Insurance).  The difficulty is coming to mutually agreeable terms for the percentage rate and definition of Gross Sales.  Under this rent structure, the landlord takes all the risk that the tenant is going to perform and as such, the percentage of Gross Sales should be higher.  Under this scenario, the Percentage Rent in a letter of intent is written as “Tenant to pay Landlord ten percent (10%) of Tenant’s Gross Sales at the Property.”  For example, if the tenant leases 5,000 square feet and first year annual Gross Sales were $1,500,000, tenant would pay landlord $150,000 in Percentage Rent ($1,500,000 x 10% = $150,000 or $30.00 per square foot.  If the landlord’s target net rent was $25.00 per square foot, the landlord’s gamble paid off, if it was $35.00 per square foot, then they fell short of their economic goal.

Gross Sales Defined:

The definition of “Gross Sales” had been well established as an industry standard, however, digital sales and the use of the brick-and-mortar store location have redefined gross sales to include digital sales fulfilled from the store.  One example of how it is written in the letter of intent is; “Gross Sales includes the sale of all goods, services, gift cards and merchandise sold or fulfilled at the Premises including any cash, credit, wholesale, retail, trade-in or digital sales fulfilled from the Premises as further defined in the lease.  From a practical viewpoint, digital sales that are fulfilled from the tenant’s premises could include 1) buy online, pick up in store (“BOPIS”), 2) buy online with curb-side pickup, or 3) buy online with delivery from the tenant premises (fulfillment).  A fulfillment sale could be more difficult for a retailer to account for and is heavily negotiated between landlord and tenant to define it in a practical way that allows for a retailer point of sale equipment to accurately capture a fulfillment sale for purposes of including it in the definition of “Gross Sales”.

For more retail real estate tips and guidance, contact James Savard at jsavard@nullmetrocommercial.com (856) 866-1900.

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