Percentage Lease

How Does a Percentage Lease Work?

The percentage lease is a commercial lease structure wherein the tenant must pay a set percentage of its excess gross sales to the landlord.

A percentage lease is an agreement in commercial real estate (CRE) where the tenant is under an obligation to pay not only the base rent but also a percentage of their gross revenue that is earned on the premises.

In practice, the percentage lease structure is most common for multi-tenant properties operating in the retail segment, such as shopping malls and shopping centers.

Conceptually, the base rent represents the “floor” in rental income that the property owner could earn, whereas the upside on the percentage share of retail sales is uncapped – albeit the risk to the tenant can be mitigated by the inclusion of a provision in the lease agreement to set a limit on the payout.

That said, a property owner, or the landlord, strives to set a higher base rent and a lower breakpoint (i.e. maximum revenue share), and vice versa for the tenant.

Unlike the fixed base rent, the variable component of the rental payment is conditional on the gross revenue of the tenant first meeting a predefined threshold per the stated terms in the lease agreement.

The percentage rent concept is therefore akin to an earn-out in M&A, since the payout mechanism is structured as a contingency fee arrangement.

There are three terms of particular importance in a percentage lease agreement:

1. Base Rent → The base rent is the fixed payment owed by a tenant for the occupancy of the space, irrespective of its recent sales performance.
2. Breakpoint → The breakpoint is the “hurdle rate” in gross revenue, which is the conditional provision that must be met for the landlord to collect the percentage rent.
3. Percentage Rent → The percentage rent is the incremental payment issued in excess of the base rent, which is a function of the agreed-upon percentage rate and breakpoint (i.e. maximum).

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Percentage Rent: What are the Pros and Cons?

Under a percentage lease agreement, the tenant normally pays a lower base rent, which functions like a “cushion” for periods with underwhelming sales and lower market demand, which is a pattern sometimes observed in cyclical industries like retail.

But the reduction in the base rent comes at a price, of course, which is the contractual obligation to share a percentage of revenue with the landlord in periods of outperformance in sales.

So the trade-off is that if the tenant reaches the pre-defined gross sales breakpoint, the landlord is entitled to receive a set proportion of the tenant’s gross revenues to offset the reduced base rent.

Given the uncertainty surrounding each factor, the terms of a percentage lease are negotiated extensively until an amicable agreement is reached, wherein the risk-return trade-off in the arrangement is deemed fair to both parties.

The incremental margin on the revenue earned reduces beyond the breakpoint (or “break-even point”). However, the burden of needing to issue payments to the landlord usually pales compared to the risk of missing a debt service obligation (e.g. interest payment, principal amortization).

The property owner can thus strategically select the businesses occupying the retail space using the data provided by the tenant to improve traffic and the collective revenue generated at the property.

The pros and cons of a percentage lease from the perspective of the tenant and the landlord are outlined in the following chart:

How to Calculate Percentage Lease

The steps to calculate the rental payment under a percentage lease agreement, including the percentage rent, are as follows.

• Step 1 → Calculate the Base Rent (Base Rent × Square Footage Leased)
• Step 2 → Determine the Natural Breakpoint (Base Rent ÷ Percentage Rate)
• Step 3 → Compute the Excess Gross Sales per Month (Gross Sales – Breakpoint Sales)
• Step 4 → Multiply the Percentage Rate by the Excess Gross Sales
• Step 5 → Add the Base Rent to the Percentage Rent (Percentage Rate × Excess Gross Sales)

Normally, the percentage rent payment is collected on a quarterly basis (or annual), rather than on a monthly basis, since the latter would be a tedious process.

Because of the variable revenue component, the property owner must periodically receive reports on monthly sales from the tenant, i.e. more transparency is required for the periodic review and to calculate an accurate pay-off.

The transparency in understanding the performance of tenants provides the property owner with more insights to improve the overall performance of the property in its entirety.

Percentage Lease Formula

The formula to calculate the rental payment under a percentage lease arrangement is the sum of the fixed base rent and the agreed-upon percentage of gross revenue over the breakpoint.

Where:

• Base Rent → The fixed rental payment expected to be collected by the property owner, irrespective of the tenant’s revenue performance. The square footage (sq. ft.) of the underlying property, or space, is normally how the rent amount is determined.
• Breakpoint → The breakpoint is the minimum threshold in gross sales that must be met for the percentage rate to come into play per the percentage rent clause.
• Percentage Rate → The agreed-upon percentage split in the excess gross revenue beyond the breakpoint.

The natural breakpoint can be derived by dividing the base rent by the percentage rate.

The standard percentage rate is 6% in the retail industry.