BlogLease AccountingUnderstanding Percentage Rent Leases

Understanding Percentage Rent Leases

what is percent rent?

As you expand your multi-unit business or franchise into new locations, you may encounter a lease structure known as the percentage rent. Particularly common in shopping centers and urban areas, this arrangement offers both opportunities and challenges for tenants. Let’s dig into the dynamics of a percent rent and the ways they can impact your franchise or business.

What is a Percentage Rent Lease Agreement?

Unlike a typical fixed-rent agreement, a percent rent lease means that tenants agree to pay a flat fee as well as a certain percentage of their gross sales, or overage rent, once their sales surpass a specified threshold known as the “breakpoint.” This breakpoint, calculated based on the minimum rent and percentage rate, determines when overage rent begins. Therefore, if your gross sales exceed the breakpoint, you’ll start paying overage rent, which is a percentage of every additional dollar in sales. Although this arrangement introduces more complexity to the lease agreement, particularly for new tenants, it can be highly advantageous for both parties when navigated wisely.

Shared Risks

Unlike a traditional lease with fixed rents explicitly stated, a percent rent lease ties a portion of rent payments to your business’s sales performance. This means that as your business thrives, so does your landlord’s income, creating a mutually beneficial scenario where both parties are invested in driving growth. The base rent is generally lower with a percent rent lease to help tenants during slower periods, while increased sales means you will pay more in overage rent.

Landlords may offer percent rent-only deals, which focus solely on overage rent without a fixed base rent, to attract tenants or assist struggling businesses. These agreements typically transition to standard leases after a certain period or once the tenant’s sales reach a specified threshold. This flexibility benefits both parties, providing tenants with a chance to be successful while ensuring landlords’ long-term returns.

Why Tenants Prefer Percentage Rent Leases

Percentage rent leases are common in retail and restaurant settings, especially in shopping malls and urban areas. They appeal to retail tenants because they offer a chance to benefit from high foot traffic and sales without having to commit to high fixed rents. This flexibility allows businesses to invest more in growth and expansion, potentially leading to higher returns over time.

Instead of sticking to a fixed rent agreement, percentage rent leases offer an alternative approach. Tenants can adjust their rent payments based on their sales, rather than being locked into a set amount that might not match their actual performance. This flexibility helps businesses adapt to changes in the market and seasonal fluctuations more effectively.

For businesses looking to grow or try new locations, percentage rent leases are beneficial. They provide an opportunity to test new ideas with lower initial costs. By paying a percentage of their sales as rent, tenants can save money and invest in activities like marketing or improving their stores. During slower sales periods, tenants pay lower rent as well.

Wooden house cut-out and keys with 'RENT' keychain, symbolizing percentage rent agreements.

Negotiation Flexibility 

One of the main benefits of percentage rent leases is how flexible they are in negotiation. Both landlords and tenants can adjust the lease terms to fit their specific needs. Landlords usually prefer a higher minimum base rent, but deciding on the percentage can be a bit of a gamble. A lower breakpoint means they start collecting percentage rent sooner, which might be worth it if the business isn’t making much profit initially. However, a higher percentage could pay off well if the location is great or if the retailer is expected to have a good year.

Tenants can suggest changes to the minimum rent, percentage rate, or breakpoint to better match their business goals. Whether they want a higher minimum rent with a higher breakpoint or a lower percentage rate to keep more profit early on, negotiations shape the lease to benefit both sides. For example, a retailer might prefer a higher minimum rent with a higher breakpoint to start making a profit at lower sales levels before percentage rent kicks in. This could be useful for new businesses just starting their marketing.

Understanding Breakpoints

Natural Breakpoints

A natural breakpoint in a percentage rent lease is a sales threshold at which the percentage rent kicks in naturally, without being artificially set by the landlord or tenant. It’s often determined by the financial performance of the business or the dynamics of the market rather than being explicitly defined in the lease agreement. This breakpoint reflects a point where the tenant’s sales reach a level that justifies the application of percentage rent based on the terms of the lease.

Unnatural Breakpoints

An unnatural breakpoint, sometimes referred to as an artificial breakpoint, is a sales threshold set artificially in the lease agreement, typically by the landlord and tenant, rather than being determined by the natural financial performance of the business. It may not align directly with the business’s actual sales volume or financial dynamics but serves as a predetermined trigger for the application of percentage rent.

While many landlords stick to the natural breakpoint, there’s no rule saying you have to. Landlords and tenants can negotiate a higher breakpoint (so you don’t have to share until you make more) or a lower one (so you share income with the landlord sooner).

You might want to suggest a percentage greater than the standard 7%. For instance, if you expect your income to rise gradually and cover the extra expense later, offering to pay a higher percentage might work. You could use this concession to get something else you want, like a lease renewal option.

On the other hand, you might want a higher minimum rent in exchange for a breakpoint above the natural point. If you think your income will go up quickly, you’d prefer not to share it with the landlord until you have to.

Reporting and Communication

Effective communication and reporting are essential for managing percentage rent leases, especially considering the potential for increased profit. Landlords typically request detailed sales statements regularly to determine when percentage rent is due and the amount they’ll receive. It’s common for landlords to allow a grace period of 10-15 days for calculating and paying percentage rent. Keeping up with this reporting is crucial for tracking variable rent payments.

Your landlord may either provide you with the exact amount of percentage rent due each month or expect you or your accountant to calculate and pay it accurately. Either way, staying on top of these financial details ensures a smooth leasing process.

A Real Life Example of Percentage Rent in a Win/Win Scenario:

Two franchisors in trench coats shaking hands in front of a glass building with a 'For Rent' sign, symbolizing a successful percent rent lease agreement.

Let’s recap what we’ve learned so far. The key components percentage rent are:

  1. Base Rent: This is the fixed amount of rent that the tenant pays to the landlord each month. It’s usually set at a predetermined amount and is independent of the tenant’s sales.
  2. Percentage Rent: In addition to the base rent, the tenant agrees to pay a percentage of their gross sales to the landlord. This percentage, known as the “overage rent,” is usually applied once the tenant’s sales exceed a certain threshold, known as the “breakpoint.” Below the breakpoint, only the base rent is paid; above it, the percentage rent kicks in.
  3. Breakpoint: This is the sales threshold at which the percentage rent begins to apply. Once the tenant’s sales surpass this amount, they are required to pay both the base rent and a percentage of their gross sales.

Now, let’s consider a real-life example involving a tenant, Sarah, who operates a boutique clothing store, and a landlord, John, who owns a retail space in a bustling downtown area.

Sarah has been running her boutique for a couple of years and has seen steady growth in sales. However, she’s hesitant to commit to a higher fixed rent as she wants to maintain flexibility and conserve cash flow for potential expansion.

John, the landlord, understands Sarah’s concerns and is open to negotiating a percentage rent lease agreement. Here’s how they structure their win-win deal:

  1. Base Rent and Percentage: They agree on a base rent of $3,000 per month, which covers the basic costs of renting the space. In addition to the base rent, Sarah agrees to pay 5% of her gross sales as percentage rent.
  2. Breakpoint Calculation: They calculate the breakpoint based on Sarah’s expected sales projections and the base rent. After careful analysis, they determine that Sarah’s annual sales need to exceed $400,000 for percentage rent to kick in.
  3. Flexibility and Grace Period: John offers Sarah a grace period of 15 days each month to calculate and pay the percentage rent. This gives Sarah enough time to review her sales data and ensure accurate payments.
  4. Communication and Reporting: Sarah agrees to provide detailed monthly sales reports to John, including gross sales figures and calculations for percentage rent. This transparency helps build trust between them and ensures accountability in the leasing relationship.
  5. Incentives for Growth: To incentivize Sarah’s growth, John offers a lower percentage rate of 3% for the first year of the lease. This gives Sarah more breathing room to reinvest profits into her business and potentially expand her operations.
  6. Option for Renewal: John includes an option for lease renewal with favorable terms if Sarah meets certain sales targets during the lease term. This provides Sarah with stability and encourages her to continue growing her business in the space.

In this win-win agreement, Sarah benefits from the flexibility of paying percentage rent based on her actual sales performance, allowing her to conserve cash flow and reinvest profits into her business. Meanwhile, John benefits from the potential for increased rental income as Sarah’s business grows, while also providing her with incentives and support for long-term success.

Managing Complexity and Administration

Percentage rent leases offer exciting opportunities, but they can also be tricky to manage. To avoid mistakes and disputes, it’s important to calculate everything accurately and keep good records.

That’s where lease management and lease accounting software comes in handy for restaurant or retail owners monitoring sales based rent payments. Here’s why using a lease and location management platform like Leasecake is a smart move to manage percentage rent leases:

  1. Accuracy: A lease management platform can do the intricate math for you, making sure you’re paying or charging the right amount every time. This reduces the chance of mistakes compared to doing it by hand.
  2. Efficiency: Doing percentage rent calculations manually takes a lot of time, especially if you have multiple leases or need to do it often. A lease and location management software speeds things up by doing the work for you, saving you time and effort.
  3. Transparency: With the right software, both you and your landlord can see exactly what’s going on with your sales, rent calculations, and payment history. This helps build trust and prevents arguments about rent payments.
  4. Reporting and Communication: Using lease management software can generate detailed reports on sales performance, rent payments, and other relevant metrics, so you don’t have to worry about coming up with these reports on your own each month.

Let Leasecake help you manage percentage rent lease agreements

Leasecake can help manage leases of all shapes and sizes, including percent rent leases. Our award winning software makes managing all of your leases easy and straightforward. We don’t just help with percent rent leases, either. Any type of lease or contract can be managed in the Leasecake platform, now integrated with our AI assistant, Cakebot.

With Leasecake you can:

  • Easily calculate percentage rent based on your lease terms and sales data.
  • Effortlessly communicate with all internal and external parties who need to be updated on percent rent payments and sales data
  • Track and report on all percentage rent payments in your portfolio

Schedule a demo today and learn how Leasecake can help manage your percentage rent.

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