Investing in commercial real estate (CRE) comes with many strategic decisions, one of which is choosing the right lease structure. One such structure is known as percentage rent, where the tenant’s rent is tied to a percentage of their sales revenue. This arrangement can be beneficial for landlords and investors, offering potential for higher returns, but it also comes with some complexities that need careful consideration.

In this blog, we will break down what percentage rent is, how it works, and when it’s best utilized in commercial leases. Whether you’re an experienced investor or just starting in real estate, understanding percentage rent can help you make more informed decisions in your investment strategy.

What is Percentage Rent in Commercial Real Estate?

Percentage rent is a lease term in which the rent paid by a tenant is partially based on the tenant’s sales revenue. This type of lease is common in retail settings, where the landlord earns not only base rent but also a percentage of the tenant’s gross income once sales exceed a specific threshold. The arrangement typically consists of two components: base rent and percentage rent.

• Base Rent: This is the fixed amount that the tenant pays each month, regardless of how well their business performs.
• Percentage Rent: This is an additional amount paid when the tenant’s sales surpass a predetermined threshold. The percentage rate is negotiated in advance and applied to sales above the breakpoint.

Sometimes, however, leases can rely entirely on percentage rent, eliminating base rent altogether. In this scenario, every dollar of the tenant’s sales contributes to the rent calculation, without a specific sales threshold.

How Percentage Rent Works in Commercial Leases

In many commercial leases, especially in retail, landlords will negotiate a combination of base rent and percentage rent. The tenant will pay a fixed amount of rent every month (base rent), but once their sales exceed a certain point, the tenant will pay a percentage of their sales as rent.

For example, a retailer’s lease may specify they will pay 8% of their sales over $3 million. If their sales for the year total $3.5 million, the landlord will receive 8% of the $500,000 that exceeds the $3 million threshold.

This lease structure allows landlords to benefit from tenants’ success, as the more the tenant sells, the more the landlord earns. For investors, this model offers the potential for increased returns in high-performing locations.

The Breakpoint: What It Means for Rent Calculations

The breakpoint is the sales figure at which percentage rent kicks in. It is a crucial element of the lease, as it determines when the tenant starts paying a percentage of their revenue in addition to the base rent.

There are two ways to define the breakpoint:

• Natural Breakpoint: This is calculated by dividing the base rent by the agreed-upon percentage. For instance, if the base rent is $250,000, and the percentage rate is 8%, the natural breakpoint would be $3.125 million ($250,000 ÷ 8%).
• Fixed Breakpoint: In this case, the breakpoint is a flat dollar amount agreed upon by both parties, without any calculations involved.

Once the breakpoint is crossed, the tenant starts paying percentage rent based on the excess sales over the threshold.

Pros and Cons of Percentage Rent for Landlords

For landlords, percentage rent leases can be an attractive way to capture more value from high-performing tenants. Here are some of the pros:

• Potential for Increased Revenue: When tenants are successful, landlords can see a significant increase in rent payments beyond the fixed base rent. This is especially beneficial in high-demand locations.
• Aligned Interests: With percentage rent, landlords share in the tenant’s success, which creates an aligned incentive. Both parties benefit when sales are strong.

However, percentage rent also carries risks:

• Volatility: The tenant’s sales can fluctuate from year to year, which affects the rent payments. This means the landlord’s income may vary depending on the tenant’s performance, making it harder to predict annual income.
• Complexity in Valuation: Since percentage rent depends on sales, it can complicate property valuation. Investors often use net operating income (NOI) to assess property value, but fluctuations in rent due to sales performance can introduce volatility in NOI, making it harder to forecast returns.

How to Negotiate and Structure Percentage Rent Leases

The key to a successful percentage rent agreement lies in the negotiations. Tenants typically prefer not to have percentage rent terms because it can increase their financial commitment. However, for tenants competing for prime retail locations, agreeing to percentage rent can be a way to secure the lease in a high-demand area.

Landlords, on the other hand, benefit from the opportunity to earn additional revenue from successful tenants. However, landlords should be cautious not to make the lease too burdensome for smaller businesses that may not have the sales volume to sustain percentage rent obligations.

When negotiating percentage rent, both parties should agree on the percentage rate, the sales threshold (breakpoint), and whether the base rent will be adjusted annually.

Challenges for Smaller Investors and Private Equity Real Estate

While larger real estate firms often deal with percentage rent leases, smaller investors may face challenges in implementing these arrangements. One significant difficulty is tracking tenant sales, which is crucial for calculating the percentage rent. Private equity firms, with their established infrastructure, are often better equipped to handle these complexities. They have dedicated teams for lease management, ensuring that sales are accurately tracked and rent is calculated accordingly.

Conclusion

Percentage rent is an effective tool in commercial real estate that allows landlords to earn more when tenants succeed. For investors, understanding how to structure and manage percentage rent leases can open up new opportunities for revenue generation. While this model can offer lucrative returns, it also comes with inherent risks, especially due to fluctuations in tenant sales. Investors should carefully consider these factors and seek professional advice if necessary when structuring their leases.

For those looking to explore this type of arrangement but unsure of how to navigate the complexities, partnering with a private equity firm that specializes in these deals can be a valuable option, providing expertise and management for smooth transactions.