A percentage lease, a type of lease commonly used in commercial real estate, is a lease arrangement where the tenant agrees to pay a predetermined rent (the base rent) in addition to a percentage of sales made when conducting business on the rental property to the landlord.
A percentage lease is a lease arrangement where the tenant pays a predetermined rent plus a percentage of sales made.
Percentage leases are common with retail businesses.
The three components of a percentage lease are the base rent, the break-even point, and the percentage rent.
How a Percentage Lease Works
In a percentage lease, the tenant pays a base rent plus a percentage of their monthly sales above a specified break-even point. Such types of leases typically occur with retail businesses.
The landlord typically allows for a reduced base rent in exchange for the upside from the variable part of the percentage lease (the percentage rent). It should be noted that the tenant generally is not responsible for property taxes, insurance, or maintenance fees in a percentage lease.
Components of a Percentage Lease
1. Base Rent
The base rent refers to the fixed monthly rent that the tenant must pay to the landlord to use the space. Generally, it is based on a certain dollar amount per square foot (for example, $6 per square foot).
2. Break-even Point
The break-even point specifies how much sales must be generated in a month above which a percentage of the sales will be given to the landlord as additional rent. For example, a break-even point of $500,000 means that the landlord will capture a percentage of sales above $500,000.
3. Percentage Rent
The percentage rent is a flat percentage that is charged on the additional amount of sales above the break-even point.
A retail tenant leases 5,000 square feet and pays $5 per square foot per month in rent. Furthermore, the retail tenant’s agreed with the landlord that if monthly sales exceed $100,000, they will pay 5% of additional sales past that threshold ($100,000) as variable rent.
Outline the three components of this percentage lease.
If the tenant does $150,000 in sales in a month, what would be the total rent for that month?
If the tenant does $85,000 in sales in a month, what would be the total rent for that month?
The base rent is $25,000 a month (5,000 x $5), the break-even point is $100,000, and the percentage rent is 5%.
If the tenant generates $150,000 in sales in a month, the total rent in that month would be $25,000 + ($50,000 * 5%) = $27,500
If the tenant generates $85,000 in sales in a month, the total rent in that month would only be $25,000. The break-even point of $100,000 was not met, so the percentage rent of 5% is not applicable.
Advantages of a Percentage Lease
The main advantages of a percentage lease for the tenant are a lower base rent and the fact that the landlord holds a vested interest in the success of the tenant’s business.
Given that the landlord is able to reap in the upside of sales beyond a break-even point, the landlord is generally more willing to provide the desired location and/or complimentary upkeep services to help the tenant capture more foot traffic.
From the landlord’s viewpoint, the key advantage is the ability to gain from the upside of the tenant’s sales beyond the break-even point. Although the base rent of a percentage lease is generally lower, if the tenant’s business is successful, the landlord is able to gain a significant amount of rent upside from the percentage rent.
Disadvantages of a Percentage Lease
For the tenant, a key disadvantage is the need to distribute a percentage of their sales to the landlord if the break-even point is exceeded. Furthermore, the tenant is responsible for accurate sales reporting and sharing that information with their landlord.
For the landlord, the main disadvantages are the lower base rent and the need to check for the authenticity and accuracy of the sales data provided by the tenant.
In short, in a percentage lease, the landlord faces asymmetrical information. They face the risk that the tenant may manipulate the sales data lower to avoid exceeding the break-even point.
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