Percentage rent is often perceived to be of benefit to landlords to reward them for having a successful shopping center that draws a large customer base benefiting the tenants in the center. In reality, percentage rent is of benefit to both tenants and landlords. The relationship of a retail tenant and a landlord is very different than that of an office tenant and landlord. The success of the office tenant’s business does not rely upon the success of the building and the masterful creation of a synergistic tenant mix as does that of the retail tenant. The landlord and tenant are really in business together to create a successful business environment that benefits both parties, and, as such, percentage rent plays a very important role.
Landlords may offer a startup tenant, a tenant reluctant to come to the shopping center or urban area, or a struggling tenant a percentage rent only deal. A percentage rent only deal is typically provided to a standard retail tenant for a short period of time (1-3 years) and generally converts to a full rent triple net deal after certain amount of years, or in better crafted deals, when a tenant hits a certain number of gross sales that justify a conversion to a standard deal. In these cases, this is a win-win for both the tenant and the landlord.
Another way percentage rent may be calculated to assist tenants in start-up scenarios is to provide the tenant with a fixed rent with an artificial breakpoint as opposed to a natural breakpoint. For those of you new to the industry, a natural breakpoint for percentage rent is derived by dividing the total base rent amount (which may be calculated per annum or on a monthly basis) by the percentage used for the percentage rent. The resulting amount is the natural breakpoint. Then, any amount over the natural break point is multiplied by the percentage used and that is the amount owed by the tenant to landlord for the percentage rent (e.g., $10.00 psf x 2,000 sf = $20,000; Assuming a 6% percentage rent; $20,000 divided by .06 = $333,333.33; then the tenant pays to landlord 6% of any excess over $333,333.33.) An artificial breakpoint is when the percentage used for the percentage rent is set, but then the actual break point is raised or lowered. By raising the break point, the landlord can help the tenant get started in its business or to attract a tenant to a location by raising the threshold by which the tenant needs to start paying the percentage rent to the landlord. It may also be lowered in cases where the base rent was lower than market and the landlord needs to make up the difference, so if the tenant does succeed, the landlord will be compensated for its gamble on starting out with a lower base rent.
The question you may be asking yourself is at what point does a tenant hit that “break even” point where it is fair to convert to a standard market deal or what percentage is a fair percentage to use for the percentage rent? The answer varies from tenant to tenant and may be more accurately determined by its use. Each industry has a different point at which it begins to make a profit and no one percentage works for each tenant within the industry. A lot of variables exist, the most important being operating expenses—how much does a tenant spend to fit-out the space, advertise, pay for the manufacture of its product, etc. in relation to the location, rent and term which ultimately determines how much the tenant thinks it will make in gross sales at the space. These are all factors that work into the calculation of what breakpoint a landlord should charge to provide a fair deal.
The best way to determine this amount is to ask the tenant directly. Most tenants are going to steer away from answering this question as they will try to negotiate a deal where percentage rent does not start at the exact point that the tenant is beginning to make a profit. Generally, six percent (6%) is the standard used, but certain industries such as auto accessories, book stores, certain apparel stores, hardware, department stores (including discount), fast food and grocery stores work off of lower percentages. Conversely, stores such as optical, amusement centers and sit-down restaurants might accommodate higher percentage rents (6% – 10%). In circumstances where the deal is a difficult one, whether due to excessively high rents or very low anticipated gross sales, a tenant may be more forthcoming in an attempt to come to achievable terms in a deal.
Ultimately, landlords and tenants are partners in one another’s business and will work together to negotiate terms that will bring success to both. While some predict limits to the use of percentage rent in a post pandemic world where tenants are a highly desired commodity, some urban areas are seeing the rise in the use of percentage rent in urban storefronts, particularly in the Washington, DC market. Percentage rent is a tool that can be used very successfully to benefit both landlords and tenants and one that I foresee staying in the retail leasing environment indefinitely.
Sandra Buchko is an attorney at Shapiro, Lifschitz and Schram. She can be reached at (202) 689-1913 or buchko@slslaw.com.