This LARG contains the following items:
Tenant Strategies for Negotiating Percentage Rent, and the Lease Clause Critique: The Pro-Landlord Percentage Rent Clause.
Number of Single Spaced Pages: 12
Taking A Long Look at the Percentage Rent Clause
This LARG looks at percentage rent issues in retail leases. The first article serves up numerous strategies the retail tenant can employ to get a fair deal on the percentage rent provisions that ultimately wind up in the lease. The Lease Clause Critique covers a pro-landlord percentage rent clause with extensive comment.
Tenant Negotiating Strategies For the Percentage Rent Clause
When negotiating new leases, a retail landlord often is more willing to alter the deal on percentage rent, than he is to alter provisions concerning the other components of the tenant's occupancy costs (e.g., minimum rent, common area maintenance costs, real estate taxes on the premises, insurance payments for the tenant's premises, etc.). It therefore behooves the retail tenant to review its negotiating strategies with regard to percentage rent in its new deals. There are a number of traditional methods that retail tenants use to reduce exposure for payment of percentage rent. They include:
- Negotiate a lower percentage (e.g., five percent instead of six percent). This is the most obvious method to reduce overall percentage rent paid by the tenant, and may be overlooked as a result. Many retail tenants have grown rapidly and have established first class retailing reputations in regional and national markets. This business reputation makes them far more desirable to retail landlords, and may provide the leverage necessary to reduce the applicable percentage payable by full percentage points or fractions thereof, especially when the tenant is precisely what the landlord wants in terms of tenant mix.
- Negotiate high breakpoints. Although many retail leases provide for payment of percentage rent with formula language (e.g., “five percent (5%) of the tenant's gross sales less the minimum rental payable under the lease“), still other retail leases use the “breakpoint method” to provide for payment of percentage rent (e.g., “the tenant shall pay percentage rent equal to five percent (5%) of all gross sales in excess of annual sales above one million dollars”). The tenant can try to negotiate the applicable breakpoint upward in its lease negotiations (e.g., try to increase the breakpoint to $1.5 million instead of $1 million), so that the negotiated breakpoint exceeds the “natural breakpoint” under the lease (i.e., the breakpoint computed by dividing the minimum rent by the percentage rent percentage). When this is done, the landlord must be careful to negotiate how partial lease years, and lease years which contain an abatement of minimum rent will be treated for purposes of computing percentage rent, since such lease years may require a proration of the breakpoint in order to be fair to the landlord.
- Negotiate no payment of percentage rent for the early years of the lease. With many retail concepts, it takes two or three years for the tenant to establish itself within its trade area and begin generating levels of gross sales which would trigger percentage rent payments to the landlord. Even so, if the tenant has good leverage, he may be able to negotiate no payment of percentage rent for the early years of the lease (e.g., the first three years of the term). This gives the tenant the opportunity to build sales quickly and pay only minimum rentals, plus other charges under the lease (e.g., real estate taxes, common area maintenance charges, etc.). The landlord may be willing to accept such a deal if he believes that it is highly unlikely that the tenant will be able to generate gross sales adequate to result in percentage rent payments during those early years anyway.
- Negotiate a “split” percentage rent deal (e.g., a four percent/five percent deal). In a split deal, the first percentage is used to calculate the breakpoint (e.g., four percent divided into the annual minimum rental of $50,000 yields a breakpoint of $1.25 million), and the second percentage provides for payment of five percent of gross sales in excess of that figure. This device has the same impact as negotiating a stipulated breakpoint in excess of the natural breakpoint mentioned above.
- Negotiate a two tiered percentage rent deal (for example, five percent of sales between $1 million and $2 million, four percent of sales in excess of $2 million). This sort of deal frequently results from a compromise between the landlord who wants five percent of sales and the tenant who wants four percent of sales.
- Negotiate items that can be “recaptured” by the tenant from percentage rent payments. Often, the tenant can negotiate certain deductions from the payment of percentage rent for other payments made by the tenant under the lease or in conjunction with the tenant's business. Examples are costs for tenant improvements expended by the tenant spread over a reasonable number of years, payments for the tenant's real estate taxes for the premises, payments for the tenant's insurance payments under the lease, and payments for common area maintenance charges under the lease. The tenant may also be able to negotiate recapture of certain extraordinary promotional expenses associated with opening its store for business. Frequently, landlords will accept some sort of recapture if the tenant has good negotiating leverage, although the landlord may permit only a portion of the cost to be recaptured (e.g., fifty percent of payments for the tenant's real estate taxes). The landlord and the tenant must negotiate whether or not the tenant can accumulate and carry forward a credit for the total amount of recapture items, or whether the tenant can only offset such amounts from percentage rents payable on a current year basis. Landlords usually try to impose maximum dollar limitations with regard to recapture items they permit, in part to avoid difficulties with lenders.
- Negotiate percentage rent only deals. This is possible where the tenant has great leverage (e.g., in the case of a unsuccessful shopping center, where the landlord desperately needs the tenant). Many jurisdictions will imply an operating covenant in percentage rent only deals, unless the lease specifically indicates no implied covenant to operate is part of the business deal between the landlord and the tenant. Courts have implied this sort of covenant in percentage only deals in the interests of fairness to the landlord, since the landlord will receive no rent if the tenant ceases to operate, even though the tenant has the continued occupancy of the premises.
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