Percentage Rent Makes a Comeback

Percentage rent has been a common lease provision for certain retail tenant leases for decades. However, it has been used sparingly during the last fifteen years due to the competition for anchor tenants and the ability of landlords to pass through all operating expenses including common area maintenance costs. Today, only about 10% of retail leases have percentage rent clauses. The percentage rent clause is primarily applied to department store anchor tenants and to smaller satellite jewelry and other higher-margin retail tenants.

The percentage rent clause was typically structured as follows:

1. ABC Department store has a 100,000 square foot store in the USA Mall.

2. ABC has a triple net rent lease with a base rent per square foot of $6 plus a 1% percentage rent based on a natural breakpoint of sales. A natural breakpoint is determined by dividing the annual rent of $600,000 ($6 per sq. ft. times 100,000 sq. ft.) by the percentage rent of 1% or $60,000,000. ABC will then pay an annual percentage rent of 1% of sales in excess of $60,000,000, its natural breakpoint. If in year two, ABC sales are $65,000,000, the percentage rent would be $50,000 (1% times $65M-$60M) and the total rent paid, exclusive of reimbursed expenses would be $650,000 ($600,000 base rent plus $50,000 in percentage rent).

3. If in year three, sales decline to $59,000,000, the percentage rent would be zero as sales are less than the breakpoint amount.

Due to the multitude of store closures, bankruptcies and contraction in the retail industry exacerbated by the pandemic, the negotiating power between the landlord and tenant is now fully in the tenant’s court. Up until about six or seven years ago, the power in retail leasing was with the landlord and tenants had to take or leave the lease deal offered by the landlord if they wanted to get into a certain shopping center or mall.

Evidence of this power was always on display at the annual ICSC (International Council of Shopping Centers) conference held in May in Las Vegas. The large REIT mall and shopping center owners had elaborate display booths with top-shelf booze, chef cut filet mignon and private meeting rooms on the convention floor for their current and prospective real estate tenants, who had to bow down to the retail owners to get their store or chain into a certain shopping center.

Today, that has totally shifted and now, the tenants hold all the cards and can demand their lease terms from that mall or shopping center owner. This means they can dictate the square foot rent they will pay and any caps or adjustments in the expense pass-throughs, that were typically triple net at 100% and of course no percentage rent clause.

Landlords are now gleefully offering lower base rents, concessions, deferred rents and for a number of tenants, 100% percentage rent. This will be especially true for the retail tenants hit hardest by the pandemic, like restaurants, fitness centers, bars, clothing retailers and department stores. The National Restaurant Association reports that in the first six months of the pandemic, nearly 100,000 restaurants closed permanently or for a long-term period.

I believe that percentage rent only clauses for retail leases will become very common during the next few years and will add a new level of risk to retail owners and investors and a benefit to tenants. Instead of paying a base rent, plus expense pass-throughs under a triple net lease, these new tenant leases may only require the tenant to pay a percentage rent.

The risk to landlords will be more variability in the effective gross income of their shopping centers when the economy slows, individual retailers incur negative financial or operational issues and fashion trends, or shopping habits change. Tenants will benefit as the rent expense on their income statement will correlate 100% with their sales revenue. If sales are rising, rent will rise in tandem. If sales are soft and falling, so will the rent. When the tenant’s sales decline, so will their rent and this new volatility will add additional risk to retail owners with percentage rent only tenants. If percentage rent only clauses become common as I believe, cap rates for retail properties will rise and remain elevated and investor returns will decline.

Joseph J. Ori is executive managing director of Paramount Capital Corporation, a commercial real estate advisory firm