In commercial real estate, particularly with retail properties, the monthly rent could be determined by how successful or unsuccessful a business is that month. When sales are high, rent is higher, but when sales are low, rent is lower. This type of commercial lease structure is called a percentage lease.
What Is a Percentage Lease?
A percentage lease is a type of lease in which the tenant pays the monthly base rent, in addition to a percentage of the sales earned while doing business on the rental property, called percentage rent. This is different from a gross lease, in which the monthly rent is set to a fixed amount, with no variation month-to-month. Percentage leases are used primarily in commercial real estate, usually with retail outlets like malls, or companies that have high sale volumes.
How Are Percentage Lease Agreements Structured?
Percentage leases are structured through two components: the base rent and the percentage of monthly or annual gross sales. The base rent is the minimum monthly rent that the lessee pays to the lessor, typically calculated per square foot.
The landlord then receives the percentage rent, which is an agreed-upon percentage of sales once the “break-even point,” or “breakpoint,” is met. Usually, the landlord and tenant will negotiate to agree on a flat amount as the break-even point, and that is included in the lease agreement. Usually, that rate is based on current industry norms for similar rentals, said Ronald Max, a Strategic Real Estate Investment Advisor at Real Estate Bees.
Once the tenant earns that flat amount, they would start paying a percentage of sales to the landlord. For instance, a tenant might agree that a percentage of any gross sales over $100,000 will go to the landlord as percentage rent.
On the other hand, some percentage leases, rather than agreeing on a fixed rate as the break-even point, will use a natural breakpoint instead. With a natural breakpoint, the base rent is divided by the agreed-upon percentage of gross sales that goes to the landlord. For instance, if the monthly rent is $1,500, and the landlord and tenant agree that 5% of sales go to the landlord, then you would divide $1,500 by 5%, which means the break-even point would amount to $30,000.
“In the quick service restaurant industry, [the percentage] is often 6% to 8% of sales,” Max said. “The base rent is then divided by the percentage rent to determine the threshold or breaking point.”
All of these rates are determined in the lease agreement, though Max noted, “It is also possible to tie percentages to other factors than sales, like items shipped or products produced.” He added that the lease structure can be “all over the board,” depending on the preferences of the landlord and tenant.
What Are the Benefits of a Percentage Lease?
For both the landlord and tenant, a percentage lease has its advantages.
For the Tenant
For some tenants, percentage leases might be beneficial because they usually come with a lower base rent per month. In addition, Max said, “a portion of their rent would be variable by being tied to sales and only paid if the location produces better than average results,” so the tenant wouldn’t be losing money.
For the Landlord
For landlords, percentage leases are attractive because they guarantee a monthly income in addition to the base rent. Property owners are also able to choose the types of business they want to rent to, seeking out companies with high sales numbers.
“If the location is very strong and sales performance is expected to be high, the landlord will share in the location’s success by receiving extra rent for the increased sales,” Max explained.
How to Negotiate a Percentage Lease as the Property Owner
As a property owner, you generally want a higher base rent and a lower breakpoint. The high rent guarantees a stable monthly income, while a low breakpoint means you’re more likely to also receive sales income, thereby increasing your total profits. It’s also a good idea for landlords to include lease provisions that allow for audits of gross sales, as well as regular sale reports so you can ensure you’re receiving the right amount.
Max also advised landlords to think about whether the tenant will reduce or manage sales by opening up at a second nearby location, or reducing their hours of operation.
“Percentage leases should have radius restrictions to prevent the store sales from being cannibalized by another store nearby,” Max said. “Other requirements should be considered to maximize results like a continuous operating clause with minimum hours of operation.”
For Retail Properties, Percentage Leases Could Be Advantageous
With retail properties, percentage leases prove to be beneficial for both the landlord and the tenant, as both parties stand to benefit from the business’s continued success. However, as is the case with all commercial lease agreements, it’s best to have a commercial real estate attorney look over your lease and determine if it is a good situation for your specific needs.