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Understanding percentage rent in a commercial lease

by on General

On Behalf of Lanard and Associates | Aug 4, 2016 | Firm News

Entering into a commercial lease can be an exciting endeavor for you and your business. Signing a lease is the next step needed before opening your retail business.

As you start looking at leases, one of your primary concerns is the rent you will be paying. However, these terms can feel confusing. The lease may refer to base rent, additional rent and/or percentage rent.  This article will discuss percentage rent.

What percentage rent means

While the term “percentage rent” gives you an idea of what a landlord will expect, it does not show you the full picture. A lease agreement with a percentage rent term means that you will pay a base rent (minimum monthly rent you pay regardless of revenues that your business achieves) and percentage rent (a percentage based on the sales generated from the business). Some leases only require that you pay percentage rent in lieu of any base or minimum rent. Clearly this has advantages over base rent plus percentage rent.

The advantage of paying percentage rent is that your rent can reflect the change in sales when your business has a month of low revenues. Then, when your company has a profitable season, both you and your landlord do better because of increased profits. However, if your business is very profitable, it can result in much higher rent than the fair market value in the area.

What if I have a month with zero profits?

A percentage rent lease does not mean you will have months where you do not need to pay rent if you also have to pay base or minimum rent. There will still be the base rent, but your total rent will be less than other months if your revenues drop.

Terms to talk about

For most businesses, the point where you become profitable could change from month to month as your expenses and sales change. To give a clear line for calculating the percentage, landlords typically determine the commencement of percentage rent by either a natural or an artificial break-even point.

For a Natural Breakpoint, this will be described as the Tenant paying X% of sales over the Natural Breakpoint.  The Natural Breakpoint is the minimum annual base rent divided by the percentage rent.  For example, if the minimum annual base rent is $100,000 per year and the percentage rent is 5%, then the Natural Breakpoint is $2,000,000.  This is the minimum sales level that must be reached by Tenant before the percentage rent will commence.  Tenant will then begin paying 5% rent over the $2,000,000 in sales earned by the business.  If the Tenant’s sales are $3,000,000 then Tenant would pay 5% of $1,000,000 (the excess over the breakpoint of $2,000,000 or $50,000 as percentage rent in addition to the $100,000 base rent for a total of $150,000 in rent for the year).

An Artificial Breakpoint will be a specified amount of gross sales (artificial, because it is an amount that is specified when the lease is signed and has no relation to the base rent amount, and your percentage rent would apply to any amount over the specified amount. So, for example, if the Artificial Breakpoint is $1,000,000, and the percentage rent is 5%, then the annual percentage rent would be the amount that is over $1,000,000 times 5%.  If the sales for a year are $3,000,000, then Tenant pays $150,000 in percentage rent for the year plus the base rent of $100,000 (as stated in my prior example) for a total rent for the year of $300,000.  As you can see, the Artificial Breakpoint in my example would mean that total rent would be double the amount that it would be with the Natural Breakpoint.

Time to negotiate

When you are considering a commercial lease, it is essential to be ready to negotiate the terms to make an agreement that is beneficial to you. Ideally, you want your base rent to be low and your Breakpoint high if you are paying percentage rent.

Negotiating a commercial lease is not a task you want to tackle on your own. It is important to talk to an experienced professional who can advocate for your interests.