Understanding and Utilizing Percentage Rent Provisions

Setting the Percentage Rent

Percentage rent is rent that is based on an agreed-upon percentage of sales in excess of an agreed-upon level of sales. The most common method of setting percentage rent is for the landlord to determine (and negotiate with the tenant) what percentage of total sales the landlord would like to receive in rent, whether as fixed rent or as percentage rent. Let us assume that the landlord and tenant agree that 5% of sales is an acceptable percentage (as it might be for a small tenant) and, for the sake of simplicity, that the percentage rent is payable annually. The percentage rent formula then can be most simply written as:

In addition to Fixed Rent, Tenant shall pay to Landlord annually as percentage rent an amount equal to five percent (5%) of the Gross Sales made in or from the Demised Premises for such year, less any amount payable under this Lease as Fixed Rent.

Another way to express the identical percentage rent would be to say:

In addition to Fixed Rent, Tenant shall pay to Landlord annually as percentage rent an amount equal to five percent (5%) of the Gross Sales made in or from the Demised Premises for such year in excess of the natural breakpoint.

What is a 'natural breakpoint'? It is simply the volume of sales that, when multiplied by the agreed-to percentage, yields the amount of Fixed Rent. (In the example, Sales Breakpoint x 5% = Fixed Rent or Sales Breakpoint = Fixed Rent / 5%.) Thus, to determine a natural breakpoint, one merely divides the fixed rent amount by the applicable percentage.

Percentage rent provisions can also use a breakpoint that is unrelated to a natural breakpoint. For example, in order to recover its store opening or other promotional expenses, a tenant may negotiate for a deferral of percentage rent between the time it hits the natural breakpoint level and some higher volume of sales. Conversely, a landlord may negotiate for the commencement of percentage rent while sales are below a natural breakpoint ' perhaps in return for a lower fixed rent. The landlord may determine that the profitability of incremental sales over that lower breakpoint level substantially increases because the tenant's fixed costs have been fully absorbed. This 'other than natural breakpoint' in our example would be expressed as follows:

In addition to Fixed Rent, Tenant shall pay to Landlord annually as percentage rent an amount equal to five percent (5%) of its Gross Sales in excess of $_____, [insert the negotiated breakpoint amount, having nothing to do with the amount of Fixed Rent, which is either more or less than a natural breakpoint].

Leases providing for only percentage rent and no fixed rent are rare. As discussed below, more often such 'percentage rent only' provisions come into play as a partial remedy if one or more of a tenant's expectations is not met, eg, co-tenancies or exclusives.

Sales and Exclusions from Sales

What are the 'sales' to which the percentage is to be applied? Typically, 'gross sales' are the measure. Consequently, the definition of 'gross sales,' along with the determination of what is to be excluded from gross sales, is a major area of negotiation in a lease. A definition of 'gross sales' and exclusions therefrom taken from the lease used by the landlord of a large Mid-Atlantic regional mall, provides as follows:

The term 'Gross Sales' shall mean the total amount in dollars of the actual sales price, whether for cash, or credit or both, of all sales of merchandise and services and all other receipts of business conducted in or from the Demised Premises, including all mail, catalog, telephone, Internet, e-commerce, or electronically received or filled orders and sales made at the Demised Premises, all deposits not refunded to purchasers, orders taken, although said orders may be filled elsewhere, and sales by any sublessee, concessionaire or licensee, or otherwise in said Demised Premises. Each sale upon installment or credit shall be treated as a sale for the full price in the month during which such sale is made irrespective of the time Tenant receives payment from its customer. A deduction shall be allowed for uncollected credit accounts, provided Tenant uses reasonable efforts to collect such accounts, and further provided that any subsequent recovery of such accounts shall be included in Gross Sales. No deduction shall be allowed for returns of merchandise which are generated from mail, catalog, telephone, Internet, e-commerce, or electronically received or filled orders and sales made outside of the Demised Premises. Gross Sales shall not include any sums from sales of merchandise for which cash has been refunded, but only to the extent of such refund, if the selling price of such merchandise has been previously included in Gross Sales. Gross Sales shall not include any sums collected from the purchaser and paid out by Tenant to the taxing authority for any sales or excise tax imposed by any duly constituted governmental authority (however, any amount Tenant receives for collecting such taxes shall be included in the definition of Gross Sales), nor the exchange of merchandise between the stores of Tenant, if any, where such exchange of goods or merchandise is made solely for the convenient operation of the business of Tenant and not for the purpose of consummating a sale which has theretofore been made at, in or from the Demised Premises or for the purpose of depriving Landlord of the benefit of the sale which otherwise would be made at, in or from the Demised Premises, nor the amount of returns to shippers or manufacturers, nor the amount of any cash or credit refund made upon any sale from the Demised Premises where the merchandise sold, or some part thereof, is thereafter returned by the purchaser and accepted by Tenant, nor sales of fixtures, which are not a part of Tenant's stock in trade.

Negotiated exclusions from gross sales might include provisions such as the following:

Gross Sales shall be reduced by (1) purchases at discounts of twenty percent (20%) or more by Tenant employees or Shopping Center employees (not to exceed three percent (3%) of Gross Sales); (2) sales of gift certificates or vouchers (to be included in Gross Sales upon redemption); (3) interest, service, finance or sales carrying charges applicable to credit transactions, including, but not limited to, VISA, MasterCard and Ameri-can Express charges; and (4) proceeds of claims for damaged or lost merchandise.

Tenants typically are required to provide landlords with sales reports and to maintain full and complete books and records that are subject to audit by the landlord.

Protecting Percentage Rent

In order to make the percentage rent calculation as 'pure' as possible, distorting factors must be eliminated or compensated for. The major distorting factor is the opening of an identical or substantially similar store of the tenant or its affiliate in such close proximity to the leased store so as to drain off sales from the leased store. This distortion is prevented by a provision found in retail leases, known as a 'radius restriction,' which is basically a covenant by the tenant not to open the same or a similar store within a specified number of miles of the leased store in question.

Most such provisions have a built-in remedy. For example, if the radius restriction is 3 miles, the provision might provide that if the tenant opens another such store within 3 miles but more than 2 miles away, gross sales for purposes of calculating percentage rent will be increased to 115% of actual gross sales; if the restriction is within 2 miles but more than 1 mile away, it will be increased to 125% of actual gross sales; and if it is within 1 mile, it will be increased to 140% of actual gross sales.

Kick-Outs and Ramp-Ups

Many landlords expect their tenants to pay percentage rent, and they consider a tenant to be less than ideal if it is not reaching its breakpoint in sales. Thus, many retail leases provide that if a tenant is not paying percentage rent over some period of time (eg, 1 year, 2 consecutive years, 2 out of 3 years, etc.), then the landlord (and sometimes the tenant also) may terminate the lease with no further liability. Because of the draconian nature of this remedy, tenants usually try for a ramp-up period during which they may build up their sales before being held to the 'percentage rent or out' standard. Typically, that is a 1- or 2-year period of deferral. (Note that the two concepts are often intertwined ' eg, 'if after the end of the second lease year, Tenant is not required to pay percentage rent in two (2) of any succeeding three (3) lease year periods, Landlord may terminate this Lease.')

Percentage Rent As a Remedy

Both in the negotiation of a lease and in its operation, percentage rent may be used as a tool to bridge otherwise insurmountable gaps or to act to preserve the lease for a period of time while the other party attempts to remedy a situation that has developed. Two such principal occurrences are the breach by the landlord of an exclusive and the landlord's failure to meet a co-tenancy provision.

Rather than place the tenant in the all-or-nothing position in which it must either waive the breach and continue under the lease or terminate the lease, some exclusives and co-tenancy provisions provide for an automatic shift from fixed rent to 'percentage rent only' ' in some cases, for a limited period of time, while the landlord attempts to cure. This makes sense, as the fluctuation in the sales level is a fairly good measure of the damage done; therefore, the rent is self-adjusting. Perhaps this remedy also might be used to bridge a gap upon a relocation to substitute space that the parties cannot agree is 'substantially similar' to the original space.

Summary

Percentage rent is a means of allowing landlords to share in the success of their tenants, which results, in part at least, from the location and traffic provided by the landlord. An agreement to use percentage rent can be fine-tuned to meet the particular needs of the parties by use of various breakpoints, deferrals, and kick-outs. It also can serve as an interim remedy in certain situations where the tenant is disadvantaged.

Myles Hannan is a partner with Linowes and Blocher LLP (www.linowes-law.com) located in Bethesda, MD.

As retailers like to say, 'The three most important factors in retailing are location, location, location.' The real value of a retail lease, however, resides in the volume of sales produced at the location; therefore, the provider of the location ' namely, the landlord ' is a key player in the retailer's success. That is why percentage rent has developed in retail leases as a way by which the landlord that provides a successful location might share to some degree in that success.

A developer setting out to construct a shopping center or strip mall typically prepares a pro forma plan for the project, thereby determining the fixed rent that must be realized from the project in order to cover its debt service and meet its desired rate of return. This is similar to what the developer of an office building would do. In the case of most retail centers, that fixed rent is a triple net rent, with the tenants paying all common area costs, property taxes, and the landlord's insurance premiums. Most pro forma plans are prepared without regard to any percentage rent; thus, percentage rent is truly the icing on the cake. However, it has also been suggested that percentage rent permits a lower fixed rent than would otherwise be the case and, therefore, lends stability to the project by enabling retailers to ride out downturns in retail activity.

This article discusses the basics of percentage rent; the various ways in which percentage rent may be determined, including the concept of 'breakpoints'; and how percentage rent works in practice.

Setting the Percentage Rent

Percentage rent is rent that is based on an agreed-upon percentage of sales in excess of an agreed-upon level of sales. The most common method of setting percentage rent is for the landlord to determine (and negotiate with the tenant) what percentage of total sales the landlord would like to receive in rent, whether as fixed rent or as percentage rent. Let us assume that the landlord and tenant agree that 5% of sales is an acceptable percentage (as it might be for a small tenant) and, for the sake of simplicity, that the percentage rent is payable annually. The percentage rent formula then can be most simply written as:

In addition to Fixed Rent, Tenant shall pay to Landlord annually as percentage rent an amount equal to five percent (5%) of the Gross Sales made in or from the Demised Premises for such year, less any amount payable under this Lease as Fixed Rent.

Another way to express the identical percentage rent would be to say:

In addition to Fixed Rent, Tenant shall pay to Landlord annually as percentage rent an amount equal to five percent (5%) of the Gross Sales made in or from the Demised Premises for such year in excess of the natural breakpoint.

What is a 'natural breakpoint'? It is simply the volume of sales that, when multiplied by the agreed-to percentage, yields the amount of Fixed Rent. (In the example, Sales Breakpoint x 5% = Fixed Rent or Sales Breakpoint = Fixed Rent / 5%.) Thus, to determine a natural breakpoint, one merely divides the fixed rent amount by the applicable percentage.

Percentage rent provisions can also use a breakpoint that is unrelated to a natural breakpoint. For example, in order to recover its store opening or other promotional expenses, a tenant may negotiate for a deferral of percentage rent between the time it hits the natural breakpoint level and some higher volume of sales. Conversely, a landlord may negotiate for the commencement of percentage rent while sales are below a natural breakpoint ' perhaps in return for a lower fixed rent. The landlord may determine that the profitability of incremental sales over that lower breakpoint level substantially increases because the tenant's fixed costs have been fully absorbed. This 'other than natural breakpoint' in our example would be expressed as follows:

In addition to Fixed Rent, Tenant shall pay to Landlord annually as percentage rent an amount equal to five percent (5%) of its Gross Sales in excess of $_____, [insert the negotiated breakpoint amount, having nothing to do with the amount of Fixed Rent, which is either more or less than a natural breakpoint].

Leases providing for only percentage rent and no fixed rent are rare. As discussed below, more often such 'percentage rent only' provisions come into play as a partial remedy if one or more of a tenant's expectations is not met, eg, co-tenancies or exclusives.

Sales and Exclusions from Sales

What are the 'sales' to which the percentage is to be applied? Typically, 'gross sales' are the measure. Consequently, the definition of 'gross sales,' along with the determination of what is to be excluded from gross sales, is a major area of negotiation in a lease. A definition of 'gross sales' and exclusions therefrom taken from the lease used by the landlord of a large Mid-Atlantic regional mall, provides as follows:

The term 'Gross Sales' shall mean the total amount in dollars of the actual sales price, whether for cash, or credit or both, of all sales of merchandise and services and all other receipts of business conducted in or from the Demised Premises, including all mail, catalog, telephone, Internet, e-commerce, or electronically received or filled orders and sales made at the Demised Premises, all deposits not refunded to purchasers, orders taken, although said orders may be filled elsewhere, and sales by any sublessee, concessionaire or licensee, or otherwise in said Demised Premises. Each sale upon installment or credit shall be treated as a sale for the full price in the month during which such sale is made irrespective of the time Tenant receives payment from its customer. A deduction shall be allowed for uncollected credit accounts, provided Tenant uses reasonable efforts to collect such accounts, and further provided that any subsequent recovery of such accounts shall be included in Gross Sales. No deduction shall be allowed for returns of merchandise which are generated from mail, catalog, telephone, Internet, e-commerce, or electronically received or filled orders and sales made outside of the Demised Premises. Gross Sales shall not include any sums from sales of merchandise for which cash has been refunded, but only to the extent of such refund, if the selling price of such merchandise has been previously included in Gross Sales. Gross Sales shall not include any sums collected from the purchaser and paid out by Tenant to the taxing authority for any sales or excise tax imposed by any duly constituted governmental authority (however, any amount Tenant receives for collecting such taxes shall be included in the definition of Gross Sales), nor the exchange of merchandise between the stores of Tenant, if any, where such exchange of goods or merchandise is made solely for the convenient operation of the business of Tenant and not for the purpose of consummating a sale which has theretofore been made at, in or from the Demised Premises or for the purpose of depriving Landlord of the benefit of the sale which otherwise would be made at, in or from the Demised Premises, nor the amount of returns to shippers or manufacturers, nor the amount of any cash or credit refund made upon any sale from the Demised Premises where the merchandise sold, or some part thereof, is thereafter returned by the purchaser and accepted by Tenant, nor sales of fixtures, which are not a part of Tenant's stock in trade.

Negotiated exclusions from gross sales might include provisions such as the following:

Gross Sales shall be reduced by (1) purchases at discounts of twenty percent (20%) or more by Tenant employees or Shopping Center employees (not to exceed three percent (3%) of Gross Sales); (2) sales of gift certificates or vouchers (to be included in Gross Sales upon redemption); (3) interest, service, finance or sales carrying charges applicable to credit transactions, including, but not limited to, VISA, MasterCard and Ameri-can Express charges; and (4) proceeds of claims for damaged or lost merchandise.

Tenants typically are required to provide landlords with sales reports and to maintain full and complete books and records that are subject to audit by the landlord.

Protecting Percentage Rent

In order to make the percentage rent calculation as 'pure' as possible, distorting factors must be eliminated or compensated for. The major distorting factor is the opening of an identical or substantially similar store of the tenant or its affiliate in such close proximity to the leased store so as to drain off sales from the leased store. This distortion is prevented by a provision found in retail leases, known as a 'radius restriction,' which is basically a covenant by the tenant not to open the same or a similar store within a specified number of miles of the leased store in question.

Most such provisions have a built-in remedy. For example, if the radius restriction is 3 miles, the provision might provide that if the tenant opens another such store within 3 miles but more than 2 miles away, gross sales for purposes of calculating percentage rent will be increased to 115% of actual gross sales; if the restriction is within 2 miles but more than 1 mile away, it will be increased to 125% of actual gross sales; and if it is within 1 mile, it will be increased to 140% of actual gross sales.

Kick-Outs and Ramp-Ups

Many landlords expect their tenants to pay percentage rent, and they consider a tenant to be less than ideal if it is not reaching its breakpoint in sales. Thus, many retail leases provide that if a tenant is not paying percentage rent over some period of time (eg, 1 year, 2 consecutive years, 2 out of 3 years, etc.), then the landlord (and sometimes the tenant also) may terminate the lease with no further liability. Because of the draconian nature of this remedy, tenants usually try for a ramp-up period during which they may build up their sales before being held to the 'percentage rent or out' standard. Typically, that is a 1- or 2-year period of deferral. (Note that the two concepts are often intertwined ' eg, 'if after the end of the second lease year, Tenant is not required to pay percentage rent in two (2) of any succeeding three (3) lease year periods, Landlord may terminate this Lease.')

Percentage Rent As a Remedy

Both in the negotiation of a lease and in its operation, percentage rent may be used as a tool to bridge otherwise insurmountable gaps or to act to preserve the lease for a period of time while the other party attempts to remedy a situation that has developed. Two such principal occurrences are the breach by the landlord of an exclusive and the landlord's failure to meet a co-tenancy provision.

Rather than place the tenant in the all-or-nothing position in which it must either waive the breach and continue under the lease or terminate the lease, some exclusives and co-tenancy provisions provide for an automatic shift from fixed rent to 'percentage rent only' ' in some cases, for a limited period of time, while the landlord attempts to cure. This makes sense, as the fluctuation in the sales level is a fairly good measure of the damage done; therefore, the rent is self-adjusting. Perhaps this remedy also might be used to bridge a gap upon a relocation to substitute space that the parties cannot agree is 'substantially similar' to the original space.

Summary

Percentage rent is a means of allowing landlords to share in the success of their tenants, which results, in part at least, from the location and traffic provided by the landlord. An agreement to use percentage rent can be fine-tuned to meet the particular needs of the parties by use of various breakpoints, deferrals, and kick-outs. It also can serve as an interim remedy in certain situations where the tenant is disadvantaged.

Myles Hannan is a partner with Linowes and Blocher LLP (www.linowes-law.com) located in Bethesda, MD.