CRC014 PERCENTAGE RENT

2019-06-07T14:11:57+00:00January 26th, 2019|Resources|

Understanding Percentage and Overage Rent in Retail Leases

 

As has been previously discussed in a few of my other articles, retail real estate rent is made up of several components to get a total Occupancy Cost for the tenant.  Retail Real Estate leases are usually written as Triple Net (NNN) where the tenant pays a “Base Rent” (also known as “Minimum Rent” “Base Minimum Rent”, “Fixed Rent”, “Fixed Minimum Rent”, Guaranteed Rent and Guaranteed Minimum Rent) plus, Real Estate Taxes, Insurance and Common Area Maintenance. In addition, Retail Tenants will commonly pay a percentage of their sales to the Landlord in the form of “Overage Rent” or “Percentage Rent”.

With Percentage Rent, the tenant will pay only a percentage of sales as rent and does not pay a fixed monthly base rent (minimum rent).

With Overage Rent, the tenant pays a monthly fixed rent known as Base Rent (or Minimum Rent) in addition to a percentage of merchandise sales after they hit a certain “Breakpoint” of sales volume.  The “Overage Rent” kicks in once sales volume has exceeded the Breakpoint.

You may ask, why would a tenant would even agree to a Percentage Rent clause in a lease? The common objection is “I just want to lease space, not become partners”.  However, a well run shopping center is a collection or curation of stores that create a complimentary whole, larger than one retailer alone. The Percentage Rent clause incentivizes the Landlord to not only select the best retailers for a Tenant Mix but also maintain cleanliness and amenities designed to drive more traffic and sales to a shopping center.

As stated above, sometimes the lease will require the tenant to pay Overage Rent as a percentage of sales once they hit a set sales volume. That set volume is called the Breakpoint. There are two different types of breakpoints, a “Natural Break” and an “Unnatural Break”.

With a Natural Break, the sales break point is determined by dividing the base rent by the percentage rent rate. Example: a tenant that agrees to pay overage rent of five percent (5%) of gross sales with a natural breakpoint; the tenant occupies 10,000 square feet with a Base Rent (Minimum Rent) of $10.00 per square foot; the annual Base Rent is $100,000 per year.

The calculation is as follows:    $100,000 / .05 = $2,000,000 for the break point.

The tenant would pay five percent (5%) of all sales over the gross sales volume of $2,000,000 per year. If the tenant sales for the year were $2,075,000 the tenant would pay 5% of the $75,000 or $18,750 in Overage Rent at the end of the year.

In this example, the tenant will pay a total of $118,750 for both Base Rent and Overage Rent for rent for the year. The Base Rent (Minimum Rent) is paid in monthly installments of $8,333.33 and the Percentage Rent would be paid after the end of the year when the tenant submits the Annual Sales Report for that year. Overage rent is either paid on an annual basis or is paid once the tenant hits the overage breakpoint, on a monthly basis.  As Base Rent increase so does the Natural Breakpoint.

With an Unnatural Break, the sales breakpoint is determined by agreement between the landlord and the tenant. Most often, this is done for national retailers. Or in certain situations where the Landlord agrees to a lower Minimum Rent the Breakpoint might be set up at a lower number as an incentive to agree to the deal with the Tenant.

Example: the Tenant might pay $100,000 per year base rent along with the five percent (5%) percentage rate. With an Unnatural Break, the Breakpoint might be set at $3,000,000.  If the Tenant’s sales were $1,750,000, their rent would only be the $100,000 Minimum Rent as stated in the lease. However, if the Tenant sales were $3,500,000, the Overage (Percentage) Rent paid would be $25,000, and the Total Annual Rent paid would be $125,000.  Some Breakpoints may be tiered, as certain sales volumes are met by the Tenant.

Most mall leases have an overage rent clause.  Many strip center leases are no longer including a percentage rent clause because the minimum rent is so high that the tenant never reaches the overage rent breakpoint.  Additionally, many lenders do not give any credit towards underwriting debt service with percentage rent. The saying from lenders goes: “You can spend the percentage rent we just won’t let you borrow against it.” So because of these factors many retail real estate landlords don’t push for the Overage Rent clause. But this is shortsighted, because it is important to monitor tenant sales so that you know which of your tenants are doing good sales volumes and which might be struggling. Even if not collecting Overage Rent it is always best practice to have a tenant report sales.

Along with the Percentage Rent lease clause you will find section immediately after and how gross sales will be calculated. It is beyond the scope of this article to go into too much detail, but there are sales which are excluded from tenants sales volume for determining the overage rent to be paid. For example, most tenants will want to deduct sales to their employees since the markup on an employee sale is fairly low to non-existent. In certain states, lottery tickets are sold by the retailer as a service and no money is made on the transaction so these would also be excluded from gross sales of the tenant.  In certain situations a Tenant may pay different Percentage Rent rates. Special care should be made in drafting leases now that Tenants are selling online and through other channels that returns deducted from the store sales volumes are from merchandise on a sale that originated at that specific store and not online. Leases should allow for the Landlord to audit the Tenant’s sales from the location.

Since both Percentage Rent and Overage Rent are dependant on the Tenant selling goods, merchandise and services for the Landlord’s specific property location the Landlord will require a Radius Restriction clause in the lease which prevents a Tenant from opening a competing store within a specified radius of the location.  Depending on the type of tenant and the demographic population density of the area these are usually written as 2 mile (or 3 Kilometers) or 3 mile or 5 mile or an entire county.  Additionally for this reason the Landlord will also want to include a Continuous Operation clause in the lease, requiring the Tenant to be open and operating with a fully stocked store and comply with the Minimum Operating Hours of the shopping center.  These three lease provisions ensure that the shopping center tenant mix is truly creating the most amount of sales volumes for every tenant within the shopping center.

Most shopping center leases require the tenant to report their gross sales on a monthly basis by the 15th or 20th day of the following month. Most leases also require the tenant to submit an annual “Certified Sales Report” at the end of the year. This report would be a fully reconciled document that would also account for any deductions or returns on sales.   The sales reports are use not only to determine the overage rent payment but also to keep track of the overall vitality and success of the shopping center. In certain malls, the mall manager distributes the compiled sales reports to the tenants so they know how they compare to their neighbors.

The percentage rate at which the tenant pays the overage rent is usually determined by the tenant’s margins. Discounters and supermarkets will have a lower percentage rent rate (1 – 3%) and specialty stores like jewelry or high-end fashion will have higher percentage rent rates (5 – 8%). A list of typical percentage rent is below. Lists like these used to be published by the Urban Land Institute (ULI) in the Dollars and Sense of Shopping Centers and by International Council of Shopping Centers (ICSC) in The SCORE.  The last time these were both published was 2006.

The term “Percentage Rent” is used to refer to both Overage Rent and Percentage Rent. However, a Percentage Rent lease has come to mean the tenant pays solely a percentage of sales for rent with no Minimum or Base Rent. Leasing Agent Legend has it that straight percentage rent was invented by the Woolworth (Five and Dime Store) company during the great depression so that they could continue in their space and the landlord will get some form of rent instead of a vacant space.

Straight percentage rent is very unusual and is typically only seen in a few situations. The most likely situation would be when a tenant exercises their co-tenancy clause (an anchor tenant vacancy or excessive vacancy in a shopping center). Additionally, if a tenant is failing and the landlord believes they either need them to prevent additional vacancies or as a temporary fix to get through a hard time a tenant might be allowed to pay straight percentage rent.  Some landlords will do a straight percentage rent with the start of tenant in hopes of incubating them to a permanent tenant status. And then, with some temporary tenants that might show up Only during Christmas season you might see a straight percentage rent.

Typically a straight percentage rent rate is higher than an overage rent rate where the tenant pays the base minimum rent.  These percentage rates can average 10 – 12% of gross sales.

PERCENTAGE RENT GUIDELINES:

This list was prepared using information obtained from TKC Consulting, the International Council of Shopping Centers SCORE Report and Urban Land Institute Dollars and Cents of Shopping Centers.  Most of this data may be dated because of the lack of reference publications currently available. These percentages should be used solely as a guideline for instructional purposes. Your legal counsel or local commercial real estate broker may have better information on trends in your area.

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