Percentage lease is a unique commercial real estate agreement where tenants pay a base rent along with a percentage of their revenue from business conducted on the leased premises. This arrangement is mutually beneficial for both landlords and tenants, aligning their interests and potentially reducing fixed costs for lessees. In this article, we’ll delve deeper into percentage leases, exploring the key components, negotiation aspects, accounting methods, and their impact on businesses. If you’re a commercial tenant or landlord, understanding percentage leases is crucial for making informed real estate decisions.
What is a percentage lease?
A Percentage Lease is a specialized type of lease agreement frequently found in commercial real estate. In this arrangement, tenants not only pay a base rent but also a percentage of their revenue earned while conducting business on the rental premises. This unique structure offers advantages for both landlords and tenants, making it an attractive option for various businesses.
Components of a percentage lease
A percentage lease comprises two primary components:
1. Base Rent (Minimum Rent): This is the fixed amount that tenants must pay regularly. The base rent in a percentage lease is often set lower than what you’d find in a standard lease, making it enticing for lessees.
2. Percentage of Sales: In addition to the base rent, tenants agree to pay a percentage of their monthly or annual gross sales from the leased premises. This percentage varies but usually kicks in after a negotiated sales breakpoint is reached.
The appeal of a percentage lease lies in the fact that it reduces the fixed costs for tenants, which can be a substantial portion of their operating expenses. Simultaneously, landlords benefit from the potential for increased revenue beyond what a standard lease could provide, aligning the interests of both parties.
The benefits of percentage leases
Reduced fixed costs
One of the primary benefits of a percentage lease is that it reduces the fixed costs for tenants. In many traditional lease agreements, businesses are required to pay a set amount of rent every month, regardless of their sales performance. This fixed cost can be a significant burden for businesses, especially during slow seasons or economic downturns.
Percentage leases address this issue by allowing businesses to pay a lower base rent, making it more affordable. When business is slow, tenants pay less, helping them weather financial challenges more effectively.
Percentage leases align the interests of both landlords and tenants. In a standard lease, landlords may have no direct stake in the success of the tenant’s business. However, in a percentage lease, as the tenant’s sales increase, the landlord’s revenue also grows.
This alignment encourages landlords to provide a desirable location and upkeep services to attract more foot traffic to the tenant’s business. Landlords have a vested interest in supporting the tenant’s success, creating a more collaborative and mutually beneficial relationship.
Challenges of percentage leases
Negotiating a percentage lease can be more intricate than standard lease agreements. Tenants and landlords must determine the sales breakpoint, which is the point at which the percentage of sales kicks in. This negotiation process can be time-consuming and may require compromise from both parties.
Additionally, the parties must decide on exclusions to the sales figure. For example, sales to employees of the store may be excluded from the calculation. Setting operating hours, discussing rights to amend the breakpoint, and establishing procedures for auditing store sales are other details that need to be worked out.
Accounting and reporting
The accounting and reporting for percentage leases can be challenging for both tenants and landlords. To comply with accounting standards, businesses must recognize their percentage lease payments as “contingent rentals” on their financial statements. This recognition occurs when the achievement of target sales levels is considered probable and estimable.
For businesses, this means keeping track of the sales figures, ensuring they meet the criteria for recognizing contingent rentals, and reporting these payments accurately. For landlords, accounting for contingent rentals received can also require meticulous record-keeping.
Percentage leases offer a unique and attractive option for both commercial tenants and landlords. By reducing fixed costs, aligning interests, and providing potential upside for both parties, they have become a popular choice in the world of commercial real estate.
However, it’s essential for businesses and landlords to approach percentage leases with a clear understanding of their complexities. Negotiation, accounting, and compliance with reporting standards are all crucial aspects of managing percentage lease agreements successfully.
In a competitive business environment, where cost optimization and revenue maximization are essential, percentage leases present an innovative solution. If you’re considering such an arrangement, thorough preparation and negotiation are key to reaping the benefits.
Pros and cons of percentage leases
Here is a list of the benefits and the drawbacks to consider.
- Lower base rent, reducing fixed costs for tenants.
- Potential for increased revenue for landlords.
- Aligns the interests of both landlords and tenants.
- The percentage of sales component only kicks in after a sales breakpoint is reached.
- Complex negotiation process between landlords and tenants.
- Impact on accounting practices for both parties.
Negotiating a percentage lease contract
Negotiating a percentage lease involves determining the crucial “breakpoint,” which is the level of sales at which the percentage lease payments start. Both landlords and tenants play a vital role in defining this breakpoint, which is linked with the base rent. While landlords might prefer a lower base rent and a lower breakpoint, tenants usually aim for a lower base rent and a higher breakpoint. The negotiation process also involves establishing exclusions to the sales figure, determining operating hours, and setting procedures for auditing store sales.
Accounting for percentage leases
The accounting for percentage leases can be intricate. Businesses, like Tapestry, Inc., which owns Coach and Kate Spade brands, refer to their portion of percentage lease payments as “contingent rentals.” These payments are recognized on their income statement when the achievement of target sales levels is considered probable and estimable. In some cases, a substantial portion of the total rent is paid through contingent rentals, highlighting the significance of percentage leases in business operations.
To illustrate the impact of percentage leases on businesses, let’s look at a couple of real-world examples:
– Tapestry, Inc.: In its fiscal year 2019, Tapestry paid approximately 30% of its total rent in the form of contingent rent (via a percentage lease). This substantial percentage of rent highlights the significance of the percentage lease in their business model.
– Signet Jewelers Limited: In contrast, Signet Jewelers Limited’s percentage lease payments accounted for less than 2% of the total rent for the same year. This variance demonstrates how different businesses can structure their lease agreements.
Percentage leases are a unique and mutually beneficial approach to commercial real estate leasing. By allowing tenants to pay a lower base rent and aligning the interests of both landlords and tenants, they can be an attractive option for various businesses. However, the negotiation process and accounting for percentage leases can be complex, making it essential for all parties involved to thoroughly understand the terms and implications of these leases.
In a world where businesses seek to optimize costs and maximize revenue, percentage leases provide an innovative solution for commercial tenants and landlords alike. If you’re considering such an agreement, it’s crucial to explore the intricacies and benefits carefully.
Frequently asked questions
What is the typical percentage range in a percentage lease agreement?
A typical percentage range in a percentage lease agreement varies but often falls between 2% to 12% of the tenant’s gross sales. This percentage depends on factors such as the type of business, location, and negotiation between the landlord and tenant.
Are there industries where percentage leases are more common?
Yes, percentage leases are more common in industries with variable sales, such as retail, restaurants, and entertainment venues. These businesses benefit from sharing the success with the landlord through a percentage of their revenue.
How do I calculate the sales breakpoint in a percentage lease?
The sales breakpoint in a percentage lease is the level of sales at which the percentage lease payments kick in. To calculate it, consider your business’s financial goals and expenses, and negotiate with the landlord. Factors like exclusions, operating hours, and auditing procedures may also influence the calculation.
Can percentage lease agreements be modified during the lease term?
Yes, percentage lease agreements can be modified, but it typically requires mutual agreement between the landlord and tenant. Modifications may involve changing the sales breakpoint, adjusting the percentage rate, or altering other terms to better suit changing circumstances.
How do percentage leases impact financial reporting for businesses?
Percentage leases can impact financial reporting by requiring businesses to recognize contingent rentals as income when target sales levels are considered probable and estimable. This affects income statements and requires accurate record-keeping and reporting practices.
- Percentage leases combine a base rent with a percentage of revenue, benefiting both landlords and tenants.
- Negotiating a favorable percentage lease involves determining the sales breakpoint, exclusions, and auditing procedures.
- Accounting for percentage leases can be complex, requiring businesses to recognize contingent rentals when sales targets are probable.