One of the things that makes commercial real estate (CRE) such an interesting asset class is that there are many ways for a landlord to structure a lease depending on which type of lease meets their financial and risk objectives. Landlords can ask prospective commercial tenants to agree to different lease terms, including the length of the lease, fixed versus percentage leases, and gross leases versus net leases.
All of these lease types come with pros and cons for the landlord and the tenant. In this article we will explore percentage rent, including what is, how it is used in commercial real estate, and how to determine the best situations to work it into a lease.
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers, and we have deep experience drafting leases to best meet the objectives of our investors. If you are an Accredited Investor and would like to learn more about our current investment opportunities, click here.
What is Percentage Rent in Real Estate?
Percentage rent is a term used in commercial real estate leases to specify that the monthly rent paid by the tenant to the landlord will be based in part on a percentage of the gross revenue generated by the tenant through the course of business at that location. Usually, under this arrangement, there are two parts to the total monthly rent paid by the tenant – there is base rent and percentage rent. It is most common for larger tenants to pay a percentage of rent to the landlord, but sometimes smaller tenants are also required to do so. It is also most common to see percentage rent used when the tenants at a particular investment property are retail tenants.
Percentage Rent in Addition to Base Rent
The base rent is a fixed amount that the tenant pays each month no matter what their sales are. This amount is agreed to in the lease contract. It is usually based on the market rent in the local real estate market and is often expressed in square footage terms (rent per square foot).
Percentage rent is an additional rent amount paid by tenants when their sales, or gross revenue, at the location exceeds a certain amount. The percentage rate and the sales threshold, or breakpoint, are agreed to in the lease.
Percentage Rent as the Total Rent
It is rare but not unheard of for rent leases to rely solely on percentage rent and to omit a base rent amount entirely. In this case, there is no sales threshold that needs to be surpassed before the percentage rate kicks in. Every dollar of gross revenue at the location will be counted when calculating the monthly rent. We will go through an example on how to calculate percentage rent below.
How Percentage Rent Plays Into Commercial Real Estate Investing
Percentage rent terms are included in many retail leases, especially for larger retail tenants. These tenants are required under the terms of the lease to pay a specified amount of base rent and then a percentage of sales after sales pass a predetermined amount. This is an important concept for commercial real estate investors to understand because it can be very advantageous to be paid a percentage of sales from a tenant that is doing well and growing rapidly. It gives the landlord a sort of synthetic equity stake in one or more of the tenants occupying their rental property because the landlord is effectively entitled to a share of the tenant’s sales once the threshold is hit. This is a very powerful model, especially for larger property owners who lease retail space to multiple tenants and even tenants with locations across the country like we do.
It’s also important for commercial real estate investors to understand that there is risk in structuring a lease to include percentage rent terms. The annual base rent might not change year-over-year, and in fact it might even increase because commercial leases often have built in rent escalators. Still, the percentage rent component can fluctuate from year to year depending on the performance of the tenant. If the tenant’s sales continue to grow, then the landlord will be entitled to a larger dollar amount of percentage rent over time. However, if sales begin to decrease, then the amount of rent received by the landlord will decrease too.
Another thing to know about the use of percentage rent in a lease is that it makes it more difficult to value the property. In commercial real estate, properties are valued using a metric known as net operating income (NOI). NOI is calculated as the gross rent less all operating expenses, including property taxes. Volatility in the tenant’s sales can lead to volatility in the amount of gross rent collected by the landlord, which in turn leads to swings in the NOI year-over-year. When real estate investors value commercial properties as part of the due diligence process, they build a pro forma financial statement. This becomes more difficult to do when the gross rent is subject to volatility.
The breakpoint is defined as the amount of sales that the tenant has to hit in a given month before the percentage rent kicks in. In other words, until sales hit the breakpoint, the tenant only pays the landlord the lower base rent amount. Let’s examine three important points to understand when it comes to the breakpoint in a percentage lease agreement.
Natural vs Fixed Breakpoint
First, it’s important to know that there are two ways that landlords can define the breakpoint in a percentage lease agreement. The first way is to use a “natural breakpoint”. A natural breakpoint is expressed in the lease as a multiple of the base rent amount. In other words, the natural breakpoint is calculated by dividing the base rent by a predetermined percentage.
Additionally, some leases include a “fixed breakpoint” that is simply a dollar amount negotiated between the landlord and tenant. It is not based on the base rent amount and involves no calculations to arrive at.
How to Calculate the Breakpoint
The percentage rent that the tenant pays to the landlord is equal to the amount of sales above the breakpoint threshold multiplied by the predetermined percentage. Let’s go through an example.
Suppose that a commercial lease stipulates that the tenant will pay percentage rent to the landlord equal to 8% on sales exceeding the natural breakpoint. This means that if the annual base rent is $250,000, then the natural breakpoint would be equal to $250,000 ÷ 8%, or $3,125,000. Recall that a fixed breakpoint does not require a calculation as it is negotiated directly between the landlord and tenant.
In this scenario, the tenant would pay the base rent amount until sales hit $3,125,000. On sales over that amount, the tenant would pay an additional percentage rent equal to 8% of sales above 3,125,000. So, if the tenant’s annual gross revenue amounts to $3,750,000, then the tenant would pay the landlord $250,000 in base rent plus $50,000 in percentage rent, or $300,000 in total. The percentage rent is calculated as (3,750,000 – 3,125,000) x 8%.
Negotiations on the Breakpoint
Negotiations over the breakpoint and the use of percentage rent in a commercial lease can be viewed from the side of the tenant as well from the side of the landlord. Tenants, or lessees, usually prefer not to have percentage rent terms included in the lease because they would rather pay the minimum rent possible, which is typically just the base rent. However, there are scenarios where it is beneficial for a tenant to agree to the inclusion of percentage rent terms in a lease. One of the more common examples is when the tenant is competing against other tenants for prime space in a high foot traffic area. In this case, the tenant can stand out in the eyes of the landlord by agreeing to percentage rent terms. Even if the tenant agrees to pay percentage rent, there is still room to negotiate over the breakpoint so that the tenant pays percentage rent on a reasonable amount of gross revenue.
Landlords, or lessors, like the idea of percentage rent because it brings about the possibility of earning extra revenue from tenants who manage to generate sales above the breakpoint. While earning the extra revenue can be a nice perk for the landlord, they need to be careful not to take it too far. Percentage rent is usually reserved for larger retail tenants because they have the resources to pay the extra amount in return for a prime location. In a multi-tenant retail center, many of the smaller tenants are mom and pop style businesses that might not have the resources to succeed under a lease that requires them to pay percentage rent. The landlord should be careful not to stifle the smaller businesses renting space in the center.
Percentage Rent & Private Equity Real Estate
Percentage rent is typically reserved for large, often anchor, tenants in commercial retail centers. Many of these centers across the country are owned by private equity real estate firms like us. Commercial centers owned by mom and pop investors or smaller groups of investors can still negotiate with tenants to include percentage rent terms in the lease, however, there are a few things that make it difficult for smaller investors to use percentage rent terms.
In order for a landlord to know how much percentage rent to expect in a given month, they need to be able to track the tenant’s sales. This can be tricky, especially for smaller investors with limited resources. Private equity firms like us usually have a team of leasing professionals who are skilled in working with the tenants to ensure that the amount of sales are being tracked and communicated accurately. This is an extra step that investors need to take in order to ensure that the lease terms are carried out correctly, and it can be difficult to do. Investors interested in entering into percentage rent leases with tenants often benefit from investing with a private equity firm that specializes in doing this.
Summary of Percentage Rent in Real Estate Investing
Percentage rent is a term used in commercial real estate leases to specify that the monthly rent paid by the tenant to the landlord will be based in part on a percentage of the gross revenue generated by the tenant through the course of business at that location. Leases that use percentage rent terms also include a base rent amount that is paid by the tenant no matter what their sales are. Once the tenant hits a certain sales threshold, known as a breakpoint, then the percentage rent kicks in.
There are pros and cons to using a percentage rent lease in commercial real estate, and it is often difficult for smaller investor groups to track the tenant’s sales in a way that ensures the percentage rent is being paid correctly. Investors who are interested in percentage rent might benefit from investing with a private equity firm that has experience with percentage rent leases.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We utilize our liquidity and decades of experience to find multi-tenanted, world-class investment opportunities for our partners.
If you are an Accredited Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.