Percentage Lease Guide: How a Percentage Lease Works

A percentage lease is a type of lease in which a tenant pays a percentage of the gross revenue they earn while operating a business on the leased premises on top of the monthly base rent. For this common lease structure in commercial real estate agreements, tenants typically pay a low base rent, which helps entice them into the business space.

When the tenant reaches a certain breakpoint—or sales threshold made on the premises—the landlord will begin to charge them a percentage of their revenue to make up for this lower base rent.

A percentage lease works by incentivizing landlords and tenants to enter into a leasing agreement that benefits both parties. Lessees benefit from paying a low monthly rent as they establish their business, and landlords benefit from the successful operation of the business by collecting a percentage of the business’s gross sales.

In this type of agreement, the landlord divide’s the tenant’s rent into two parts: the base rent (also called the minimum rent) and a percentage rent provision stipulating the percentage of the tenant’s gross sales that the landlord will receive. The landlord and tenant will negotiate a breakpoint, a threshold at which the tenant will begin to pay the landlord a percentage of their business’s gross sales.

Typically, a lower base rent means a low breakpoint. The parties can establish a natural breakpoint by dividing the base rent by a specific percentage. Otherwise, the tenant and landlord can negotiate the specific breakpoint together.

Here are some of the advantages of a percentage lease agreement for both tenant and landlord:

1. 1. Lower base rent: Tenants in percentage leases benefit from this type of agreement because the initial base rent is typically less expensive than it would be in a standard lease. The lower rental cost can be helpful when sales are slower as you start to establish your business.
2. 2. Mutually beneficial: A landlord has a vested interest in their tenant's business succeeding under this agreement, which means that they will do everything in their power to increase foot traffic to the business. They are more motivated to provide maintenance services and a good location such as a shopping center or multi-tenant property, which can be advantageous for retail tenants.
3. 3. Percentage yield for landlords: Landlords stand to benefit from a percentage lease once a tenant's business becomes successful. At this point, they can earn a greater yield from annual gross sales than they would from a standard lease.

Here are some of the disadvantages of a percentage lease:

1. 1. Less money on new leases: New commercial tenants may take a long time to build up to the breakpoint they need to reach to pay their landlords a percentage of their sales. Hence, landlords will have to wait before they benefit from the percentage rent provision.
2. 2. Difficulty negotiating: Tenants will push for higher breakpoints on a percentage lease, which can disadvantage landlords. If the negotiated breakpoint is too high, a small business can survive on a modest income without paying the additional rent percentage.
3. 3. Tenant fees: A tenant is not entitled to keep all of their revenue in this leasing model because they owe a percentage of their sales to their landlord. In a standard lease or a net lease, they would keep all of their sales.
4. 4. Accurate tenant reporting: The percentage lease model relies on accurate sales reporting from tenants but incentivizes the reporting of lower earnings, which can create distrust between tenants and landlords.

Percentage and net leases are popular leasing models in commercial real estate, with a few key differences. A percentage lease requires the tenant to pay a base rent and a percentage of their gross sales once they reach a certain revenue threshold. Alternatively, the landlord does not collect a percentage rate of the tenant’s gross sales in a net lease.

The tenant pays the total rent and property taxes, insurance, and maintenance fees in a net lease. Conversely, the tenant is not responsible for property taxes, insurance, or maintenance fees in a percentage lease.

All investments, including real estate investments, come with inherent risks which may involve the depreciation of assets, financial losses, or legal ramifications. The information presented in this article is for educational, informational, and referential purposes only. Consult a licensed real estate or financial professional before making any legal or financial commitments.

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