Don't Fear Percentage Rent
Percentage Rent in a lease often causes a big concern for retail tenants when negotiating a lease, but the danger is to spend too much time on negotiating Percentage Rent, when often Percentage Rent never has to be paid by the Tenant.
Percentage Rent is often confusing and intimidating to tenants. It looks like the Landlord is just reaching into your pocket because they can and stealing hard-earned dollars. We can debate the reality of the situation, but the theory of percentage rent is based on the value of the location of your business bears to your overall success.
How To Calculate Percentage Rent
Percentage Rent is normally calculated as an annual percentage that the tenant has to pay on those gross sales that exceed a certain threshold. That threshold is often referred to as the "breakpoint." It's very helpful to have an illustration to see the equation that we use to determine the breakpoint and calculate percentage rent.
Breakpoint = Annual Rent / Percentage
So, let's assume that the annual rent is $100,000 and the percentage rent is 6%. To calculate the breakpoint, we divide 100,000 by .06. This gives us $1,666,667 as the breakpoint. Ok, now the question is, if our sales exceed $1,666,667 in this year, what "extra" rent do we have to pay the landlord. Let's assume we had $1,800,000 in gross sales in the year. We would owe percentage rent on $1,800,000 - $1,666,667 or $133,333. So 6% of 133,333 is $7,998. Most of the time, the question I ask tenants is: "If you are making 1.8MM a year in gross sales, do you care about paying an extra $8K a year in rent?" Most of the time (if your costs and wages are kept in check), the answer is "No." Right, let's fight about something that is certain to have an immediate impact on the health and well-being of your business: Tenant Improvements.
In fact, stated a different way, if I guaranteed that you would gross $1,800,000 next year if you paid the Landlord an extra $8,000, would you be willing to pay the Landlord that money?
For nearly all retailers, the answer is "Yes!" Moral of the story, we should spend our energy fighting other items in the lease, rather than concentrating on Percentage Rent too much.
A few things to be careful of when negotiating percentage rent clauses in your lease are:
- Get a natural break (i.e., using the formula I cite above) and not some artificially low breakpoint
- Make sure the break point increases as your rent increases
- Look closely at the way "Gross Sales" is defined in the lease to make sure you are not including items that should be excluded or credited (like deductions for gift cards, refunds, rewards purchases, perks to employees and owners, etc.
With these tips in mind, percentage rent should be less intimidating in your lease. All things being equal, I would rather fight about limited guaranties, tenant improvement allowances, hours of operation, assignment/subletting rights, or tenant passthroughs rather than percentage rent. There are much better places in the lease to maximize your outcome than in fighting about removing the percentage rent clause