Through the years, it's been my experience that many business owners, while extremely cautious with their commercial real estate purchase agreements, operating agreements and core commercial contracts, give surprisingly little thought to their lease agreements. This holds true for even the savviest of operators - until they get bitten. Unfortunately, when clients come in with an executed lease agreement it is usually to late to assist.
Most businesses that rent space understand the distinction between base rent and CAM (i.e., additional rent comprised of operating expenses, insurance and real estate taxes), however, fewer understand the ins and outs of percentage rent clauses. In Denver, percentage rent clauses were mostly exclusive to volume restaurant leases once, and even then not all. In recent years however, they've become something I see in many retail oriented leases, especially for locations in highly desirable locations - which describes most of Denver these days!
A percentage rent clause entitles the landlord to a cut of a tenant's gross sales revenue in addition to monthly base rent and CAM pass throughs. While there are several methods of calculating the ratio, the most common ratio is a percentage of gross sales above a natural breakpoint. For example, "5% of Gross Sales over a Natural Breakpoint." To the uninitiated this terminology may sound a bit esoteric but in reality it's quite simple: the natural breakpoint is the annual base rent divided by the percentage. So, if annual base rent is $50,000.00, and the percentage is 5%, the natural breakpoint is $1,000,000.00. In addition to base rent and CAM, the tenant must pay 5% of it's annual gross revenues over $1,000,000.00. So if a site generates $1,750,000.00 of gross revenue, $37,500.00 of percentage rent is due to the landlord. Simple?
One clause warranting close attention is the definition of "Gross Sales." Like the definition of "operating expenses" with respect to CAM provisions, the initiated tenant should negotiate for both customary and fair carve outs from gross sales. One obvious example is revenue derived from vending machines used by employees only. A less obvious but important example is credit charges due by the tenant to third parties attributable to credit sales; this can add up to a substantial amount for most businesses in today's economy where point hoarders (I know I am one!) use credit cards for a large portion of their monthly consumer spending. Discount sales to employees is another example. In a recent negotiation for a restauranteur I received pushback from the landlord on this request - in the end the landlord agreed to the exclusion so long as that amount was capped at "3% of total gross sales to employees in a Lease Year." The list of gross revenue exclusions that are warranted in lease negotiations are informed by the specific business a tenant is engaged in, what is common in a given center's lease negotiations, industry custom and of course, a given landlord's willingness to negotiate.
Summit 6 Legal represents a wide range of local and national retailers and restauranteurs and is adept at helping our clients negotiate fair terms in their LOIs and Lease Agreements.
Contract Wisely!
David C. Uhlig