A percentage lease agreement is a notable arrangement in commercial leasing. In this arrangement, tenants pay base rent plus a percentage of monthly sales, blending the interests of landlords and tenants by tying rental costs to business success.
When To Use
Percentage lease agreements are beneficial in specific commercial real estate scenarios, particularly in the retail sector. Consider using a percentage lease agreement in the following situations:
- For retail businesses with fluctuating sales volumes
- When landlords want to share in the success of high-performing tenants
- In shopping malls or high-traffic commercial areas
- For new or unproven businesses to reduce initial fixed costs
- To align landlord and tenant interests in property maintenance and marketing
- In seasonal businesses where sales vary significantly throughout the year
- When tenants prefer lower base rent in exchange for sharing a percentage of sales
- To provide landlords with potential upside in strong economic conditions
Key Components of a Percentage Lease Agreement
In a percentage lease agreement, understanding the three main components is crucial for both landlords and tenants:
1. Base Rent:
- This is the fixed monthly rent that the tenant agrees to pay regardless of their sales volume.
- It’s typically calculated on a per square foot basis, such as $6 per square foot.
- This provides a predictable cost that tenants can budget for each month.
2. Break-Even Point:
- This critical figure represents the sales threshold that must be exceeded before percentage rent is applied.
- For example, if the break-even point is set at $500,000, any sales above this amount will contribute to the percentage rent.
- It defines when additional rent calculations begin.
3. Percentage Rent:
- This is the additional rent paid by the tenant, calculated as a percentage of sales over the break-even point.
- The specific percentage is predetermined and agreed upon in the lease agreement.
- It aligns the tenant’s success directly with the landlord’s benefit, as the landlord will receive more rent as the tenant’s sales increase.
How is a Percentage Lease Calculated?
To calculate a percentage lease, follow these steps:
- Calculate the Base Rent: Multiply the base rent rate (per square foot) by the total square footage leased.
- Determine the Natural Breakpoint: Divide the annual base rent by the percentage rate agreed upon in the lease. This breakpoint represents the sales level at which the tenant begins paying additional rent based on their sales.
- Compute the Excess Gross Sales: Subtract the Breakpoint Sales from the actual Gross Sales to determine if there are any excess sales subject to the percentage rent.
- Calculate the Additional Rent: If there are excess gross sales, multiply the agreed-upon Percentage Rate by the Excess Gross Sales to find the additional rent due.
- Total Rent Calculation: Add the Base Rent and the Additional Rent (if any) to determine the total rent due for the period.
Example
Lease Terms:
- Retail space: 2,000 square feet
- Base rent: $20 per square foot per year
- Percentage rate: 6% of gross sales
- Actual gross sales for the month: $100,000
Step 1 – Calculate the Base Rent:
- Annual Base Rent = $20 × 2,000 sq ft = $40,000
- Monthly Base Rent = $40,000 ÷ 12 = $3,333.33
Step 2 – Determine the Natural Breakpoint:
- Annual Breakpoint = Annual Base Rent ÷ Percentage Rate
- $40,000 ÷ 0.06 = $666,666.67
- Monthly Breakpoint = $666,666.67 ÷ 12 = $55,555.56
Step 3 – Compute the Excess Gross Sales:
- Monthly Gross Sales: $100,000
- Excess Gross Sales = $100,000 – $55,555.56 = $44,444.44
Step 4 – Calculate the Additional Rent:
- Additional Rent = Excess Gross Sales × Percentage Rate
- $44,444.44 × 0.06 = $2,666.67
Step 5 – Total Rent Calculation:
- Total Monthly Rent = Base Rent + Additional Rent
- $3,333.33 + $2,666.67 = $6,000
In this example, the tenant would pay a total of $6,000 for the month, consisting of $3,333.33 in base rent and $2,666.67 in percentage rent based on their sales performance.
Steps to Create a Percentage Lease Agreement
Step 1: Identify Required Clauses
To start, you need to identify and compile the essential clauses that should be included in your percentage lease agreement. These typically cover areas such as the base rent, the calculation method for percentage rent, the definition of gross sales, and any exclusions from gross sales that won’t count towards the percentage rent.
Step 2: Drafting the Agreement
Once you have all the necessary clauses, begin drafting the agreement. Ensure that the terms are clear and precise to avoid any ambiguity. It’s crucial to specify how and when sales will be reported and how the percentage rent will be calculated and paid.
Step 3: Review and Revise
After drafting, review the agreement thoroughly. It’s advisable to have a legal expert or a lawyer specializing in commercial leases review the document. They can provide insights and suggest revisions to ensure that the agreement is legally sound and mutually beneficial.
Step 4: Finalizing the Document
Finally, once the revisions are made and both parties agree on the terms, proceed to finalize the document. Both the landlord and the tenant should sign the agreement, and it’s recommended that witnesses be present during the signing to validate the contract further.
Benefits and Drawbacks of Percentage Lease Agreements
Landlord Pros
- Can earn higher gross revenue when tenants are successful
- Incentivizes selection of synergistic businesses to boost foot traffic
- Encourages better property maintenance to attract more customers
Landlord Cons
- Lower base rent might not be compensated if the tenant’s sales don’t exceed break-even point
- Need to diligently verify tenant’s sales reports
- Time-consuming process prone to disputes if discrepancies arise
Tenant Pros
- Lower base rent, alleviating financial pressure during slow periods
- Landlords have a vested interest in tenant’s success
- Potential for better maintenance and support from landlords
- More favorable business environment
- Possibility of higher sales
Tenant Cons
- Parting with a percentage of sales revenue above break-even point may affect profitability
- Requirement for meticulous monthly sales reporting can be burdensome
- Potential for conflicts with landlord due to inaccuracies in reporting
