As covered in my article, What is Percentage Rent?, percentage rent is additional rent paid to the landlord which is based on a percentage of gross sales; the key term being “gross” sales. This concept appears relatively straightforward, but in practice its calculation and application require a deeper level of analysis that is unique to each business/tenant. In order to effectively negotiate and benefit from percentage rent, tenants must understand how it works in practice.
Gross sales do not mean gross profits (far from it). Profit is the difference between a business’ gross sales and their operating expenses, which include but are not limited to rent, costs of goods, salaries/payroll, etc. As a result, a business’ expense-to-sales ratio is the most important metric to understand and consider when negotiating percentage rent. A business that generates $1M in gross sales with an expense-to-sales ratio of 70% nets $300k/year in profit. For every dollar of sales the tenant makes $0.30. More on this later…
The amount of gross sales after which percentage rent applies is called the breakpoint. There are 2 ways of determining the breakpoint: naturally and artificially. The natural breakpoint is calculated by dividing the amount of percentage rent (as a percent) by the base annual rent. For example, if landlord and tenant agree to 8% percentage rent with a base rent of $20/SF/yr and 1,000 SF the natural breakpoint is $250,000 in gross sales ($20/SF/yr x 1,000 SF = $20,000/year / 8%). There is an inverse relationship between the amount of percentage rent and the natural breakpoint; meaning the higher the percent the lower the breakpoint. As a result, it stands to reason that the higher percentage rent a tenant is willing to pay the lower base rent the landlord should be willing to accept. The lower the breakpoint the sooner the landlord can offset and exceed any discrepancy between the base rent and market rent.
Artificial breakpoints are just that; artificial. Landlord and tenant simply agree to an amount of gross sales after which percentage rent applies. Artificial breakpoints are more for the benefit of the tenant because they can structure the terms based on their own projections and guarantee a minimum level of profit before having to share a percentage of said profits. This ties directly into the importance of expense-to-sales ratios because the percentage of shared profits is significantly higher than the percentage rent paid on gross sales.
Using the previous example of a business with a 70% expense-to-sales ratio we can calculate the actual cost of percentage rent. If the tenant agrees to pay 6% on gross sales above the natural breakpoint of $1M and generates $1.1M they will owe the landlord $6k in additional rent ($100k x 6% = $6k). On its face, 6% may not seem like much, but when applied in the context of the expense-to-sales ratio this amount is magnified. The tenant’s profit is 30% of the additional $100k in gross sales or $30k. Percentage rent is based on gross sales not profit so instead of netting $30k the tenant is only taking home $24k ($30k – $6k = $24k). This makes the true impact of the percentage rent 20% ($6k / $30k = 20%).
This is not to say that percentage rent is always negative. On the contrary, it can be an extremely useful tool in customizing lease terms to fit a tenant’s specific needs and business model. The percentage, breakpoint, and base rent can all be negotiated until a deal is reached that benefits both landlord and tenant. For tenants it is crucial to understand their expense-to-sales ratio so that they can negotiate terms that minimize their fixed expenses (rent) all while maintaining a minimum level of gross profit.