What is Percentage Lease in Commercial Real Estate?
In commercial real estate, a percentage lease is a form of lease that requires a retail tenant to pay a percentage of their revenues in addition to a base rent, which will usually be calculated per square foot (PSF). Percentage lease arrangements are often open to significant negotiations before signing, since tenants and landlords may have different financial needs. These arrangements are typically only made with larger retail tenants, such as department stores at a shopping mall, but can be made with tenants of any size.
How Percentage Leases Work in Commercial Real Estate
Typically, a percentage lease arrangement will be structured around a "breakpoint," a specific amount of revenue above which the landlord will begin collecting their percentage. For example, a percentage lease agreement could set a fixed breakpoint of $20,000/month, with a 20% percentage. In that case, if the store made $18,000 in revenue that month, they would pay nothing, but if they made $30,000, they would pay $2,000 to the landlord ($30,000- $20,000 = $10,000 * 20% = $2,000). In reality, however, the average percentage usually hovers around 7%. Some percentage leases have a tiered system, in which the percentage rent changes as sales increases, though this is somewhat less common.
How Commercial Landlords Calculate Natural Breakpoints
In many cases, commercial landlords don't simply choose a random number when calculating the breakpoint for a commercial tenant. Instead, they take a tenant's base rent and divide it by the percentage of sales they want (usually 7%). Using this calculation, they can arrive at what's called the "natural breakpoint."
Natural Breakpoint = Base Rent/Percentage Rent (Overage Percentage)
For example, if a tenant was being charged $10,000 a month in rent, they would typically be charged 7% of all revenues above $142,857 during that period (10,000/0.07 = 142,857). It's important to remember that, as base rent goes up, so does the natural breakpoint.
The Benefits of Percentage Leases for Landlords and Tenants
Percentage leases can have a strong upside for tenants, who want to reduce their fixed costs, as well as for landlords, who want to increase their property's potential monthly revenues. In most cases, a tenant can negotiate down their potential base rent if they're willing to set a lower breakpoint, give a higher percentage of their revenues, or both. A tenant may also be willing to set a lower breakpoint or increase the percentage of their revenues for other concessions, such as a lease renewal option.
Audits, Restrictions, And Other Percentage Lease Considerations
To maximize their potential profits of a percentage lease, a landlord may require an annual or semi-annual audit of a tenants sales, and may also ask that they avoid opening up any other locations within a specified area, as not to dilute their sales revenues. A percentage lease agreement will also need to specify what exactly is and is not included in a tenant's gross revenues.
Despite the benefits of percentage leases, they're not for everyone. If a tenant or landlord doesn't feel comfortable with a percentage lease agreement, they may both want to go with a higher base rate and avoid a percentage lease in the first place.