Colorado Real Estate Journal - December 3, 2014
In a commercial real estate setting, the majority of leases between a landlord and a tenant provide for the fixed payment 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 defaults under the terms of 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 considerations related to the negotiation of a percentage rent clause. Origins of Percentage Rent. Percentage rent did not become common until the Great Depression. (William J. Hammet, Percentage Leases: Is There a Need to Imply a Covenant of Continuous Operation?, 72 Marq. Law Rev. 559 [Summer 1989]). At that time, most tenants were unable or unwilling to pay high fixed base rent. (S. McMichael, Leases – Percentage, Short and Long Term 34 [5th ed. 1959]). Accordingly, landlords, facing high vacancy and defaulting tenants were forced to recast the lease because they viewed it as a necessary device to keep a good tenant in business. (1 M. Friedman, Friedman 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 clauses were widely accepted in the retail industry and still remain so. Benefits of Percentage Rent. The lease that provides for percentage 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 higher 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. (Hammett, 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 business risks, a landlord may receive more rental through the percentage rent provision as the tenant’s business operation becomes increasingly successful. Id. (citing Landis, supra). The benefit to the tenant is that a portion of rental expense can be “fixed” as an acceptable percentage of gross sales. Id. This provides a tenant with the necessary flexibility and “cushion” in the early years of its business. Id. (citing Comment, The Lessee’s Obligation 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 landlord is locked into a long-term lease with what turns out to be belowmarket 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 market 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. 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 percentage negotiated by the parties, typically calculated as base rent divided by this negotiated overage percentage. For example, if annual fixed rent was $20,000 and the overage percentage was 5 percent, 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 determined during initial lease negotiations between the parties. Negotiating 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 n g power (e.g., a national retailer vs. a single store operator), a landlord’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. Considerations in Negotiating a Percentage Rent Provision. In negotiating a lease with a percentage rent provision, there are additional considerations besides just the natural or artificial breakpoint, 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 definition, while a tenant will seek to exclude as much as possible from the definition (particularly trying to 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 treated: 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 calculation 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 Traditional Shopping Center Lease, 6 Tex. Wesleyan L. Rev. 85 (Fall 1999). Other related considerations in negotiating a lease containing percentage rent are retail radius restrictions (preventing a tenant from opening up another store within close proximity to the store paying percentage rent and thus cannibalizing sales); continuous operation provisions (requiring tenant to operate continuously to maximize gross sales); audit and recordkeeping requirements so landlord can check the tenant’s reporting; and the timing of payment and reconciliation (often the landlord will want to be paid monthly, but a “true up” should be performed at the end of the year to address seasonal sales variations). Conclusion. A percentage rent provision in a retail lease can be an equitable means of sharing risks and protecting the interests and financial stability of the parties. At the same time, if the provision is negotiated without taking into consideration the implications on the lease as a whole, a percentage rent provision can be drastically one-sided. Because of this, is it important that retail landlords and tenants consider historical sales data and financials, review estimated sales projections and reach out to as many resources as possible for guidance (i.e., real estate brokers, property management companies and attorneys) before entering into a lease contemplating the payment of percentage rent