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Law & Accounting
I
n a commercial real estate
setting, themajority of leases
between a landlord and a
tenant provide for the fixed pay-
ment of rent together with a share
of certain expenses. As a result, a
landlord bears little of its tenant’s
business risk; at least until a tenant
defaultsunder the termsof its lease.
The exception to the rule occurs in
retail leases, where tenants pay a
percentage of their gross income
(usually in excess of some base
amount) as rent in addition to fixed
rent. This article briefly outlines
the origins of percentage rent, the
general benefits (and detriments)
thereof, the forms percentage rent
provisions take and some consider-
ations related to thenegotiationof a
percentage rent clause.
n
Origins of Percentage Rent.
Percentage rent did not become
common until the Great Depres-
sion. (William J. Hammet, Percent-
age Leases: Is There a Need to
Imply a Covenant of Continuous
Operation?, 72Marq. LawRev. 559
[Summer 1989]). At that time, most
tenantswereunableorunwilling to
pay high fixed base rent. (S. McMi-
chael, Leases – Percentage, Short
and Long Term 34 [5th ed. 1959]).
Accordingly, landlords, facing
high vacancy and defaulting ten-
ants were forced to recast the lease
because they viewed it as a neces-
sary device to keep a good tenant
in business. (1 M. Friedman, Fried-
man on Leases, note 2, § 6.1 [2d ed.
1983]). By the time tenants moved
to shopping centers in the suburbs
after World War II, percentage rent
clauseswerewidelyaccepted in the
retail industry and still remain so.
n
Benefits of Percentage Rent.
The lease that provides for percent-
age rent creates a more integrated
business relationship between the
parties than a lease without such
a provision. A landlord shares in
the risk and rewards of a tenant’s
business; if the tenant performs
well, the landlord receives a high-
er rent in the form of percentage
rent. When properly negotiated, a
lease that provides for percentage
rent should enable a landlord to
achieve a fair rental on the value or
productivity of its property. (Ham-
mett, supra, note 4 [citing Landis,
Problems in Drafting Percentage
Leases, B.U.L. Rev. 190] [1956]). By
attracting aggressive tenants who
are willing to share the initial busi-
ness risks, a landlord may receive
more rental through the percentage
rent provision as the tenant’s busi-
ness operation becomes increas-
ingly successful. Id. (citing Landis,
supra). The benefit to the tenant is
that a portion of rental expense can
be “fixed” as anacceptablepercent-
age of gross sales. Id. This provides
a tenant with
the necessary
flexibility and
“cushion” in
the early years
of its busi-
ness. Id. (citing
Comment, The
Lessee’s Obli-
gation Under
a Percentage
Lease, 60 Nw.
U.L. Rev. 677
[1965].
In today’s
retail leasing
market, it is
not uncommon for leases to extend
10 or more years. It is difficult to
predict what a fair market rental
rate may be for such an extended
period of time. With a fixed base
rent, a landlord may charge too
much, making the tenant’s rental
expense burdensome, which may
cause a tenant to end up relocating
or closing before it had given the
location enough time to mature in
the market. Alternatively, if a land-
lord is locked into a long-termlease
with what turns out to be below-
market fixed rent, the landlord is
receiving a limited return on its
investment while the tenant could
be profiting from record-breaking
sales. By applying a portion of the
rental income to percentage rent,
both parties are tied into the mar-
ket conditions and the viability of
the shopping center. Neither party
wins if the tenant goes dark and
both parties have the incentive to
keep their operations as effective
and profitable as possible.
n
Calculating Percentage Rent.
Percentage rent is based upon a
percentage of a tenant’s gross sales.
Traditionally, the parties will agree
to either a natural or an artificial
breakpoint in a lease. A natural
breakpoint reflects the amount of
gross sales over an overage per-
centage negotiated by the parties,
typically calculated as base rent
divided by this negotiated over-
age percentage. For example, if
annual fixed rent was $20,000 and
the overage percentage was 5 per-
cent, the natural breakpoint would
be $400,000 (i.e., $20,000/0.05),
and the tenant would therefore
be required to pay the landlord,
in addition to its $20,000 in annual
fixed rent, 5 percent of all annual
gross sales in excess of $400,000.
Alternatively, the breakpoint may
be artificially fixed (i.e., an absolute
gross sales amount or gross sales
per square foot), which is deter-
mined during initial lease negotia-
tions between the parties. Negoti-
ating an overage percentage, in the
case of a natural breakpoint, or a
artificial breakpoint, will depend
on,
among
other factors,
each party’s
b a rg a i n i ng
power (e.g., a
national retail-
er vs. a single
store opera-
tor), a land-
lord’s vacancy
rate, a tenant’s
financials, and
the parties’
expectations
as to the total
amount of rent they seek to receive
and pay, respectively, based on
their estimated projections of the
tenant’s gross sales.
n
Considerations in Negotiat-
ing a Percentage Rent Provision.
In negotiating a lease with a per-
centage rent provision, there are
additional considerations besides
just the natural or artificial break-
point, one of which involves the
definition of “gross sales.” When
defining gross sales in a lease, a
landlord will want every dollar
received by a tenant, regardless of
origin, to be included in the defi-
nition, while a tenant will seek to
exclude as much as possible from
thedefinition(particularlytryingto
exclude costs that may reduce the
amount retained from such sales,
such as credit card fees or bounced
checks). If gross sales are defined
broadly, a tenant should attempt
to negotiate a higher breakpoint
or lower fixed rent. Alternatively,
if a tenant negotiates a number of
exclusions from the definition of
gross sales, the landlord should
ensure that the breakpoint is lower
or fixed rent is higher.
A contention between landlords
and tenants that has emerged over
the last 20 years is whether and
how Internet sales are to be treat-
ed: Should items bought online be
included in the definition of gross
sales?What if such sales are picked
up at the store? What if they are
delivered out of store inventory?
The debate still goes on and at this
point the best advice is to be sure
this issue is addressed clearly in
the lease, as courts give the most
weight to the plain meaning of
what is to be included in the cal-
culation of gross sales. See Taft
Realty Corp. v. Yorkhaven Enters,
Inc., 150 A.2d 497 (Conn. 1959);
Jennifer E. Doty, The Effects of
Electronic Commerce on the Tra-
ditional Shopping Center Lease, 6
Tex.WesleyanL. Rev. 85 (Fall 1999).
Other related considerations in
negotiating a lease containing per-
centage rent are retail radius restric-
Jonathan G.
Nash
Associate, Senn
Visciano Canges PC,
Denver
David C. Camp
Director, Senn
Visciano Canges PC,
Denver
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