What is a Percentage Lease?

A Percentage Lease is a type of lease agreement commonly used in commercial real estate, especially for retail properties. In a percentage lease, the tenant pays a base rent plus a percentage of their gross sales above a certain threshold. This arrangement allows landlords to share in the tenant's success and aligns the interests of both parties.

Percentage leases are commonly used in commercial real estate, especially in retail settings such as shopping centers and malls. This type of lease agreement involves a tenant paying a base rent plus a percentage of their monthly sales revenue to the landlord. This arrangement aligns the interests of both landlords and tenants around the success of the business, offering unique benefits to each party.

How Percentage Leases Work

**1. Base Rent + Percentage of Sales:

• Base Rent: Tenants pay a fixed minimum base rent regardless of sales. This ensures that landlords receive a steady income even if the tenant's sales are low.
• Percentage Rate: On top of the base rent, tenants also pay a percentage of their gross sales after achieving a certain amount of sales, known as a "breakpoint." The percentage rate and the breakpoint are negotiated and set in the lease agreement.

**2. Calculating the Breakpoint:

• Natural Breakpoint: This is calculated by dividing the annual base rent by the agreed-upon percentage. For instance, if the base rent is $30,000 per year and the percentage rate is 6%, the breakpoint would be $500,000 ($30,000 / 0.06). Sales beyond this amount would be subject to the percentage rent.
• Artificial Breakpoint: Sometimes, the breakpoint is set artificially in the lease and may not be based on the base rent calculation. This figure is negotiated based on anticipated sales levels and other factors.

Why Landlords Offer Percentage Leases

**1. Revenue Maximization:

• Shared Success: Landlords benefit from the tenant's success because their income from the property increases as the tenant's sales increase. This is particularly advantageous in high-traffic areas where tenants are likely to make substantial sales.

**2. Attracting and Retaining Tenants:

• Lower Base Rent: Offering a lower base rent with a percentage component can be more attractive to new businesses or those in highly variable markets, making properties more competitive.

**3. Market Adaptability:

• Flexibility in Economic Fluctuations: Percentage leases provide a buffer against economic downturns. If a tenant's sales decline, their overall rent decreases, potentially preventing tenant turnover during tough economic times.

Why Tenants Agree to Percentage Leases

**1. Reduced Risk:

• Lower Initial Costs: Tenants benefit from lower base rents, which decreases their fixed costs and financial risk, particularly valuable for new or expanding businesses.

**2. Alignment of Costs with Revenue:

• Scalable Expenses: As rent adjusts based on sales, tenants find their rental costs more closely aligned with their cash flow and profitability, easing financial pressures during slower business periods.

**3. Incentive for Landlords:

• Supportive Landlord Relationship: Because the landlord's income is tied to the tenant's success, landlords might be more motivated to maintain the property and support the tenant in maximizing their sales potential, including marketing the location or center and ensuring it's appealing and accessible.

Conclusion

Percentage leases are a strategic choice for both landlords and tenants in scenarios where tenant success translates directly into increased foot traffic and sales, such as in retail environments. This lease structure helps reduce financial risk for tenants and aligns the financial incentives of both parties, potentially leading to a more collaborative landlord-tenant relationship. For landlords, it allows participation in the tenant's success and can lead to higher potential returns compared to a fixed rent model, especially in prime locations with high consumer engagement.