When renting commercial real estate, it’s critical to understand the various forms of leases so that the landlord and tenant have the most practical and advantageous arrangement possible. Net leases and gross leases are the most well-known of these lease kinds. However, because of the benefits they provide to both the tenant and the landlord, a percentage lease is also extensively utilized in commercial real estate. Learn everything you need to know about a percentage lease in real estate here with a detailed example.
What is Percentage Lease?
Simply put, a percentage lease is a sort of commercial real estate lease. The defining element of this sort of lease, also known as percentage rent, is that, unlike a net lease or gross lease, it requires giving the landlord a share of any profits made by the tenant.
A percentage lease is most typically utilized when negotiating with a retail tenant due to its structure, especially if that tenant will be joining a multi-tenant retail space such as a mall or shopping center.
The appeal of this lease arrangement is that it might benefit both the landlord and the renter. On the one hand, the landlord assists the tenant in attracting more traffic by carefully picking businesses that complement each other well in the area. Having a nail salon, clothes store, restaurant, and tailor in the same shopping area, for example, may encourage customers to walk from one store to the next, improving overall foot traffic for all tenants.
On the other hand, as tenants’ money grows, so does the landlord’s right to higher rent. A percentage lease, once again, is arranged so that the landlord receives a portion of the tenant’s revenue. If the tenant generates more sales as a result of increased foot traffic, they will be required to pay a share of that money to the landlord under this sort of lease.
How Does a Percentage Lease Work
A percentage lease requires the tenant to pay a base rent plus a percentage of their monthly sales that exceed a predetermined break-even mark. Such leases are most commonly found in retail establishments.
In exchange for the upside from the variable portion of the percentage lease, the landlord often allows for a lower base rent (the percentage rent). It should be emphasized that in a percentage lease, the renter is often not responsible for property taxes, insurance, or maintenance fees.
Negotiable Terms in a Percentage Lease
It is critical to address the lease length and who will be liable for running expenses when negotiating a percentage lease. You should also talk about base rent levels, breakpoints, and percentage rents.
Let’s take a closer look at the parameters of a percentage lease to see what we can agree on:
#1. Monthly Rent
A commercial lease agreement with a percentage rent clause will also include a base rent value. This minimum rental cost is typically established on a per-square-foot basis.
The basic rent of a percentage lease agreement must be remitted to the landlord regardless of the tenant’s revenue. It is the very minimum that the landlord can anticipate earning from each renter in this lease circumstance.
#2. Breakpoint
Until a particular threshold of gross sales is reached, the landlord will not begin collecting a percentage of the tenant’s income. This figure is usually represented in dollars and is known as the break-even point, which is also known as an article or natural breakpoint. Many small business owners prefer a natural break-even point versus an artificial break-even point because it ensures that the break-even threshold is greater than the gross sales revenue required to pay the base rent.
#3. Percentage Rent
Finally, both parties must come to an agreement on a percentage rent. This statistic is often a flat percentage that represents the amount of income above the breakpoint. For example, landlords and tenants may agree that 7% of gross sales above the breakpoint will be subject to percentage rent.
What Factors Should You Consider While Negotiating a Percentage Lease?
When negotiating a percentage lease, you should discuss things like the lease length and who is liable for what running expenses. However, the most prevalent considerations directly related to the percentage rent provision are listed below.
As the Lessee:
As a lessee, you’re looking for low base rent and a high break-even threshold. However, because you’ll almost certainly have to pick between the two, selecting a greater break-even point is frequently more advantageous. This is especially true for newer small business owners because a greater break-even threshold permits them to profit at lower gross sales before the percentage rent provision kicks in.
You should also agree on whether forms of revenue are subject to percentage rent. For example, you probably don’t want any revenues from sale items that were later returned to count.
As the property owner:
Landlords, on the other hand, are usually looking for a greater minimum rent and a lower break-even point. While charging a higher minimum rent can provide you with a more consistent income, a lower break-even threshold and/or a higher percentage rent may enhance your total profits, especially if your potential renter has a well-known brand or established client base.
You’ll also want to include lease provisions that enable audits of gross sales and frequent sales reports so you know you’re getting the extra rent you’re owed.
How To Calculate a Percentage Lease
Percentage leases are calculated using a simple equation that represents the total rent a renter must pay in place of the base minimum rent. The tenant is liable for the landlord’s triple net costs and expenses, in addition to the percentage rent.
Begin with the three variables listed below:
- Percentage rent.
- Gross sales.
- Rental square footage
Fill in the blanks with the following variables:
(Negotiated Percentage X Gross Sales) / 12 = Price Per Square Foot
If the landlord’s desired rent is higher than the price per square foot, they have fallen short of their goals. However, if this figure exceeds the aim, the landlord’s method is successful.
It’s also worth noting the distinction between lease and rent. The former refers to long-term restrictions, whilst the latter refers to a monthly agreement.
What Are the Benefits of a Percentage Lease?
The following are some of the benefits of a percentage lease agreement for both the tenant and the landlord:
#1. Lower first base rent:
Tenants in percentage lease profit from this type of agreement because the initial base rent is usually less expensive than in a normal lease. The cheaper rental cost can be advantageous when sales are slow while you launch your business.
#2. Mutually beneficial:
Under this agreement, a landlord has a vested interest in their tenant’s business flourishing, which means they will do everything in their ability to increase foot traffic to the business. They are more inclined to provide maintenance services as well as a favorable location, such as a shopping center or multi-tenant property, which can benefit retail tenants.
#3. Landlords benefit from percentage leases when a tenant’s business succeeds.
They can now receive a higher yield on annual gross sales than they would from a standard lease.
What are the Disadvantages of a Percentage Lease?
The following are some of the drawbacks of a percentage lease:
#1. Less money on new leases:
It may take a long time for new commercial tenants to reach the breakpoint required to pay their landlords a percentage of their sales. As a result, landlords will have to wait before reaping the benefits of the percentage rent provision.
#2. Difficulty negotiating:
Tenants often seek larger breakpoints on a percentage lease, putting landlords at a disadvantage. If the agreed-upon breakpoint is too high, a small firm can exist on a low revenue without paying the increased rent percentage.
#3. Tenant fees:
In this leasing model, a tenant is not entitled to keep all of their revenue because they owe a percentage of their sales to their landlord. They would keep all of their sales in a regular lease or a net lease.
#4. Accurate tenant reporting:
The percentage lease model relies on accurate sales reporting from tenants but also incentivizes renters to report lower revenues, which can lead to distrust between tenants and landlords.
What is the Percentage Retail?
The percentage of retail space leased on a percentage basis is around 7%. This sort of lease agreement is most commonly used by businesses with substantial sales volumes. It may, however, apply to a small firm seeking to build a significant foot traffic presence.
The terms are frequently cheaper for the store because they do not have to pay additional rent if sales are slow for a period of time.
Net Lease vs. Percentage Lease
Both a percentage and net lease is typical leasing arrangement in commercial real estate, but there are several key differences between them. Commercial tenants who sign a percentage lease must pay a base rent plus a percentage of gross sales after they achieve a certain revenue level. Net leases, on the other hand, exclude gross sales, and the tenant is liable for base rent, maintenance, insurance, and taxes.
Let’s take a closer look at net leases to better understand their key differences:
What is a Net Lease?
Net leases are commercial lease arrangements in which the tenant pays a portion or all of the property’s taxes, insurance, and maintenance costs in addition to the base rent. Net leases are widespread in commercial real estate and can take the form of single net leases, double net leases, or triple net leases.
What Is the Difference Between a Net Lease and a Percentage Lease?
With a few major distinctions, percentage and net leases are typical leasing arrangements in commercial real estate. A percentage lease requires the tenant to pay a base rent as well as a percentage of their gross sales after they reach a specified income level. In a net lease, the landlord does not collect a percentage of the tenant’s gross sales.
In a net lease, the tenant pays the total rent, property taxes, insurance, and maintenance expenses. So in contrast, in a percentage lease, the renter is not responsible for property taxes, insurance, or maintenance payments.
Conclusion
A percentage lease is one example of a business lease agreement. However, when used effectively, it can benefit both the landlord and the tenant. Consider this your guide to negotiating these leases to your advantage. With this information, you should be able to negotiate percentage lease terms that suit you.
Percentage Lease FAQs
What is an example of a percentage lease?
A percentage lease, for example, can demand a tenant to pay 7% of any sales that surpass $25,000 in any given month. Seven percent is a frequent percentage lease rate, so be wary if a landlord wants to charge you ten percent or twelve percent.
What is a percentage rent clause?
A percentage rent clause states that if the tenant makes a specific amount of gross sales in a given year, they must pay the landlord a percentage of those gross sales as additional rent.
How do you calculate an expense stop?
For example, if the actual operating expenses in the first year were $9.50 per square foot, the Expense Stop would be set at $9.50 per square foot, and the tenant would be responsible for any expenses in excess of $9.50 per square foot in any following year.
What percentage of sales should go to rent?
Commercial renters should be able to spend 5% to 10% of their gross sales per square foot on rent. Sales per square foot are calculated by dividing your gross sales by the square footage of the location.
