Right now a number of retailers are having a difficult time making ends meet. Some retail tenants have found ways to adapt in the "new normal," offering to-go service, outside seating, online sales, or other means to continue generating revenues, but others have struggled, putting a lot of stress on commercial landlords.
The challenging economic circumstances have motivated some landlords to look into percentage rent as a possible lease structure to help them during difficult times. Learn what percentage rent is, how it works in commercial real estate, and whether it's a good solution for struggling commercial landlords in the economy today.
What is percentage rent?
Percentage rent is a type of lease structure used in commercial real estate (CRE), particularly in the retail sector, such as multi-tenant shopping centers, single retail spaces, or malls. The lease charges a percentage rent based on gross income rather than a flat rate each month, which could either be in lieu of or in addition to a base rent amount. A percentage lease can be a great way for landlords to take advantage of increased revenues earned by the tenant without putting an additional burden on tenants if high revenues are not achieved.
How percentage rent works
Base rent is the set rental amount established in a lease. For example, if a free-standing clothing retailer is renting a 2,500-square-foot store at $10 per square foot, their base rent for the year would be $250,000, or $20,833 per month. In a percentage lease, a percentage rent ranging from 3% to 10% but most commonly 5% would be charged for any gross revenues that exceed a specified revenue "breakpoint," in this example we'll say revenues of $1 million. Any revenues that exceed the breakpoint would be charged a percentage rent.
In this example, we can say revenues for the year were $1,280,000. The tenant would need to pay an additional $14,000 (5% of $280,000) to the landlord. If the threshold is not met, no rent percentage is charged to the tenant. The landlord can choose to only charge a percentage rent without any base rent or charge a discounted base rent with a lower threshold for the breakpoint, meaning they are more likely to achieve market rent but only if revenues are achieved.
How percentage rent can help struggling landlords and tenants right now
Revenues for many retailers have been extremely unstable this year, making rental rates and rental collections unstable for commercial landlords. Certain businesses like grocery stores and other essential service retailers have seen huge spikes in revenues from high demand during the initial onset of the pandemic. Others, like bars, restaurants, and nonessential retailers, suffered major losses at the onset of the pandemic, especially those that were unable to sell their goods to-go or online. This volatility has put pressure on many commercial landlords and led to missed opportunities for landlords who aren't utilizing percentage rent to allow them to collect additional rental income from the tenants experiencing sudden surges in revenues.
By using a percentage lease, a landlord can potentially benefit from earning additional rental income if the retailer experiences increased sales. It can also benefit struggling tenants by establishing a fair rental rate that may be slightly discounted. This increased revenue earned from the retail tenants that are doing well can be used to offset those who may be struggling to pay rent, have requested forbearance, or are paying partial rent for the time being. This is definitely not a solution for the retail tenants who simply cannot pay, but it is a way to hopefully earn additional income to offset any losses. This strategy, among others like adding pandemic clauses to their leases, can help those who may be struggling currently.