The Percentage Lease Concept is Poised to Spread

The pandemic has opened the door to a whole host of negotiations about rent abatements, other concessions and lease adjustments between retail landlords and their tenants. 

“The pandemic has highlighted the need for many leases to have a greater degree of flexibility to accommodate significant business interruption better,” says Omar Eltorai, market analyst at Reonomy.

Eltorai says the pandemic has produced a greater interest in more flexible lease terms. Now, he expects the percentage lease concept to grow more popular. “While not new, the percentage lease concept will likely become more widespread – particularly in retail,” he says. 

Percentage have generally only existed for large retailers, according to Eltorai. “The way that the leases work is that they have one fixed rent component and one variable rent component,” he says. “The fixed component is the base rent, which is generally below market rate, and then the variable component is a percentage of the sales generated by that retailer at that property.”

The lease protects the tenant, but gives the landlord the upside potential of collecting more than the market rent. And when sales are worse than expected, the tenant pays below the market rent. “The tenant likes this agreement because they have locked in a lower fixed rental cost, and the owner likes it because they have filled the space and have upside potential if the retailer does well,” Eltorai says.

As the economic pain caused by COVID plays out, Eltorai expects lease terms to change more dramatically. But some changes made to existing leases were emergency measures to help remedy the initial shock and may not be applicable to future tenants.

 “The first changes we’ll see are bespoke in nature – and unique between lessor and lessee – as property owners negotiate with tenants who have experienced a significant business interruption to find terms that allow for some leniency during these times,” Eltorai says. “After that, there may be more sweeping changes of lease terms, as there is a greater understanding of what seems to work well for both lessors and lessees across different businesses.”

Eltorai expects some of the changes made to existing leases to ultimately be applied to new leases, but adoption depends on tenant-specific scenarios. “New lease negotiations will be influenced by the pandemic because both the owner and tenant will be considering a pandemic scenario – even if they do not make it a focal point of the negotiation,” he says.

While Eltorai doesn’t expect a drastic overhaul or re-evaluation of all leases, he does think that it is appropriate to expect that there will be a wider variety of lease terms after the COVID crisis. “Much of the variety that will be added will be in the form of greater flexibility based on the presumed business interruption risk of the tenant and the owner’s willingness to share that risk,” he says.