Percentage Lease: What it Is and How it Works
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A percentage lease is an excellent option for landlords who want to entice ideal tenants. A percentage lease is a lower base monthly rent with an added percentage of their gross sales. A percentage lease can be a win-win for everyone involved when utilized strategically.
This article defines percentage leases as well as how they work, negotiable terms, and other vital details commercial landlords should understand.
What is a Percentage Lease?
A percentage lease is a real estate legal document for a commercial lease where the tenant pays a percentage of revenue in addition to their base rent amount. The tenant usually pays a lower base rent, which can become a selling point of the lease. After a specific sales threshold or breakpoint, the landlord can begin charging them a gross revenue percentage to offset the low base rent.
This web page also defines percentage leases.
How Does a Percentage Lease Work in Real Estate?
Percentage leases are often used with multi-tenant retail properties.
Here’s an example of how a percentage lease works in real estate for greater clarity and understanding :
- MacKenzie Flynn is a real estate entrepreneur
- She sees an opportunity to purchase a vacant outlet center
- Flynn believes that if she attracts the right tenants, she could profit considerably using percentage leases long-term
- All tenants receive a low initial base rate of $20 per square foot plus 7 percent of gross sales above the natural breakpoint
- Flynn drafts her percentage lease agreements to account for these terms with complementary businesses
- Over five years, she fills the outlet center with high-end retailers and makes property improvements
- Not only is Ms. Flynn’s rental business booming, but her clients are enjoying heavy foot traffic
- Each year, her tenants’ sales increase by 15 percent each year, which means that Ms. Flynn saw an increase in commercial rental income as well
- Flynn’s percentage lease strategy was the right decision
This example shows that the strategic use of percentage leases can help aligned parties make a considerable profit while strengthening the local commerce ecosystem. However, these types of lease agreements are not suitable for every landlord, tenant, business, or industry, meaning that you should carefully consider your options before offering them to prospective tenants.
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Who Benefits from a Percentage Lease?
A percentage lease can benefit either the tenant or landlord. Certain tenants may enjoy percentage leases due to the lower monthly fixed rental costs. Their use often applies to high traffic areas such as shopping malls, outlets, and shopping centers since percentage leases can benefit tenants with high and low sales volumes.
Percentage leases benefit the property owner as they allow for the strategic selection of the businesses that will occupy the retail space. As a result, strategic leasing can increase customer traffic to the space, allowing the landlord to negotiate a percentage of sales over time. However, not all businesses may be willing to agree to a percentage lease, which may limit the landlord’s options.
A percentage lease is not appropriate for every commercial rental situation. Always seek legal advice if you have questions about how to structure and negotiate your lease terms. For example, you may want to consider gross leases for commercial office lease rentals or modified gross leases for entire building leases.
Terms to Negotiation in a Percentage Lease
When negotiating a percentage lease, it’s essential to discuss the lease term and who will be responsible for operating expenses. You will also want to discuss base rent amounts, breakpoints, and percentage rents.
Let’s take a closer look at the terms to negotiate in a percentage lease :
Term 1. Base Rent
A commercial lease agreement that offers a percentage rent clause will also include a specified amount of base rent. Typically, this minimum rental cost is calculated on a per-square-foot basis.
Regardless of the tenant’s revenue, the base rent of a percentage lease agreement must be remitted to the landlord. It is the bare minimum amount that the property owner can expect to earn from each tenant in this leasing situation.
Term 2. Breakpoint
The landlord will not begin collecting a percentage of the tenant’s income until a certain level of gross sales is reached. This amount is typically expressed in dollars and is referred to as the break-even point, defined as an article or natural breakpoint. Many small business owners prefer a natural break-even point over an artificial one because it ensures that the break-even point is greater than the gross sales revenue required to pay the base rent.
Term 3. Percentage Rent
Finally, both parties must agree on a percentage rent. This figure is typically a flat percentage representing the income amount above the breakpoint. For example, landlords and tenants may agree that percentage rent will apply to seven percent of gross sales above the breakpoint.
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Percentage Lease vs. Net Lease
Percentage and net leases are common leasing models in commercial real estate, but they have some essential distinctions. Percentage leases require commercial tenants to pay a base rent plus a percentage of gross sales once they reach a specified revenue level. On the other hand, net leases do not include gross sales, and the tenant is responsible for base rent, maintenance, insurance, and taxes.
Let’s take a closer look at net leases for a better understanding of their fundamental differences :
What is a Net Lease?
Net leases are commercial lease agreements in which the tenant pays a portion or all of the property’s taxes, insurance, and maintenance costs in addition to the base rent. In commercial real estate, net leases are common and often come in the form of single net leases, double net leases, and triple net leases . Keep in mind there are different net leases and the costs the tenant is responsible for will vary.
How is a Percentage Lease Calculated?
You calculate percentage leases using a straightforward equation representing the total rent a tenant must pay in place of base minimum rent. The tenant is responsible for the landlord’s triple net costs and expenses along with percentage rent.
Start with the following three variables:
- Variable 1. Percentage rent
- Variable 2. Gross sales
- Variable 3. Rental square footage
Insert these variables into the following equation:
(Negotiated Percentage X Gross Sales) / 12 = Price Per Square Foot
If the landlord’s target rent is above the price per square foot, they fell short of their objectives. However, if this number is higher than the target, the landlord’s strategy pays off.
We should also note that lease vs. rent differ. The former connotes long-term limits, whereas the latter signifies a monthly agreement.
What is the Percentage in Retail?
The percentage in retail under percentage leases is about seven percent. Businesses most frequently use this type of lease agreement with high sales volumes. However, it may also apply to a small business looking to establish a high foot traffic presence.
The terms are often more affordable for the retailer since they don’t have to pay more for rent if sales are slow for a given period.
Get Legal Help with Percentage Leases
Commercial lease lawyers can help you with percentage leases. They offer insight on drafting the documents you need and how to negotiate a commercial lease. Get in touch with a commercial lease lawyer from your state today.
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