Many leases for retail spaces, including restaurants, include terms that require the tenant to pay to the landlord a percentage of profits earned from gross sales. This “percentage rent” payment is over and above the monthly base rent, operating costs and taxes that the tenant also pays the landlord under the lease.
For retail or mixed-use shopping centers, landlords will be looking to have different types of stores and other tenant uses, with the goal of bringing as much customer traffic to have a profitable project and to increase all tenants’ sales. It is possible (but not in all instances) that the landlord may be charging you a lower base rent amount, and in exchange for the benefit that the landlord is providing through the diverse tenant occupancies and increased business, the landlord will want to share in the increased business. However, as a tenant, you need to not only understand and recognize that this profit sharing is going on, but you need to know if the process set forth in the lease is reasonable and fair.
Most percentage rent provisions will require the tenant to pay a percentage of their gross sales after they exceed a certain amount of dollars. Some landlords will set a specific dollar amount the tenant must meet before being required to pay percentage rent. In some instances, it is a calculation that provides for payment if the tenant’s gross sales exceed the total amount of base rent being paid by the tenant under the lease. These essentially are similarly calculated. For example, if the tenant’s base rent for the entire year is $150,000 ($12,500 per month), then percentage rent might be five percent (5%) of all gross sales above $3,000,000 (with the calculation being determined by taking the base rent of $150,000 and dividing it by 5% to get the $3,000,000 threshold number). This threshold number should increase each year as your base rent increases each year as well (as most rent increases annually). This is called a “natural breakpoint” due to the fact that it is based off a percentage of the base rent, with the logic that a tenant should only pay the percentage rent on sales over and above what is required to pay as the base rent. In some leases, there is an “artificial breakpoint”, which is simply a dollar amount of sales the parties agree on, which number may not be based upon or related to the amount of base rent being paid by the tenant.
The landlord will want to define what is included in gross sales as broadly as possible. However, to be fair to the tenant, certain items should be excluded from the definition and calculation. Appropriate exclusions from percentage rent, include, but are not limited to: (i) any exchange of merchandise between different stores owned by the tenant if not for the purpose of consummating a sale from the leased premises; (ii) returns to shippers or manufacturers; (iii) cash or credit refunds to customers on transactions otherwise included in gross sales, provided the full value attributed to a trade-in item at the time the sale is made is included in gross sales; (iv) sales of trade fixtures and store operating equipment after use thereof; and (vi) any government sales or excise tax.
In order to determine how much percentage rent may be due, the landlord will require the tenant to meet certain reporting requirements. For example, the landlord may require the tenant to provide a detailed gross sales statement within fifteen (15) days after the end of each calendar month, and at the point during the year when the reports show that the tenant has exceeded the percentage rent threshold, the tenant would include payments with the monthly gross sales report. At the end of each year, the parties should review and calculate the entire prior year to determine if all payments were properly calculated and paid. The tenant will be required to use modern cash registers and computers which show, record and preserve all items making up gross sales and usually are required to keep those records for a certain amount of time, most likely three (3) years for landlord to come back and audit if necessary.
If you find yourself as a tenant negotiating a lease with a percentage rent provision, you should carefully evaluate if it is properly, fairly and reasonably written.
If done correctly, both parties will be happy with the process. The landlord will receive additional monies from tenants, and the tenants will be willing to pay the monies because they are exceeding expectations due to the vibrant and active retail center in which they have leased space and which the landlord has put together and planned.
Contact Michael Faerber by email at firstname.lastname@example.org or any of our attorneys in our real estate lawyers at McMillan Metro, P.C. if you have any questions about the foregoing or if we can be of help to you with your real estate or other legal matters for you or your business.