If You Are Going To Do Percentage Rent, Do It Right (The Rest Of The Story)

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Last week, we wrote about 65% of what we wanted to say about percentage rent. Today, we’ll write the other 65%. Jumping right in:

Let’s say a party goods store expects to, and actually does, have sales of nine million dollars in its first twelve months of business. The tenant knows that because it is moving from the same size space across the street. If sales were spread evenly over the year it would amount to $750,000 a month or $2.25MM a calendar quarter. Now, Halloween is the big, big one for a party goods store. The year-end holidays are pretty big too. In fact, one can expect that instead of the final quarter of the year accounting for 25% of the year’s sales, it will account for 45%. Let’s call that $4,050,000 or $1,350,000 each month. Yes, October will be bigger than either November or December; November will be smaller than December.

Why did we write all of that? Well, today’s posting is about percentage rent. So, we’ll hypothesize that the party store tenant will be paying such rent on all yearly sales in excess of $12,000,000. Some readers, not suspecting where we are going, will say: “Why do I care about percentage rent in your example? Annual sales will fall $3,000,000 short of the $12MM sales breakpoint?” “Exactly the point,” Ruminations would respond.

The most common way a “short” or “partial” percentage rent year is handled, and that means in landlord form leases, is to prorate the sales breakpoint based on how many days were in the short year. So, in our example with a $12MM sales breakpoint (for each calendar year) and the tenant opening for business on October 1, almost every landlord suggests that the sales breakpoint be prorated for a “partial” year. That would, for the last calendar quarter of the year, mean 1/4 of the $12,000,000. That’s $3,000,000. With sales of $4,050,000 in that first quarter of operations, the party goods tenant would be paying percentage rent equal to 5% of $1,050,000. That’s $52,500 even though its sales from October 1 through the following September 30 will only come to $9,000,000 and that’s $3,000,000 below the sales breakpoint. Setting aside “fairness,” does this seem like what the parties intended?

Now, there is a simple way to avoid this problem, especially at the beginning of a lease’s term. Percentage rent could be calculated on a lease year basis, the first one being from 12 to 13 months beginning with the date a tenant opens for business. Aside from that being an unusual definition (and still prone to distortion, though far less than the “normal” approach), it wouldn’t address the same issue, a short year, when it happens at the end of a lease’s term – a sales period of less than 12 months. In addition, it would invoke a separate accounting period for reporting and “true-up.”

So, what does Ruminations suggest? How about making the first percentage lease year include the first full calendar year in the lease’s term PLUS the short stub in the prior calendar year? How about making the final year one that includes the last full calendar year in the lease’s term PLUS the final short stub of the lease-ending final year?

In our example, the first percentage lease year would run 15 months from opening on October 1 through the end of the following calendar year. The sales breakpoint for that 15 month period would be $15MM (that is, the $3MM for the October 1 – to year end period AND the $12MM for the following calendar year). With sales of $4,050,000 for that first calendar quarter and $9,000,000 for the next calendar year, you’ll have sales of $13,050,000 measured against a $15MM sales breakpoint.

At the end of the Lease, if the lease term started with that last calendar quarter, the landlord gets a fair shake because the first 9 months of each calendar year would otherwise be artificially reduced because they would be the weaker sales period for a party goods store. Making that final percentage rent “year” into a 21 month period (9 months plus one year) would more accurately compensate the landlord.

And, it isn’t just a party store problem. Year-end holiday sales can represent a significant portion of sales for many retailers. At an extreme, if a tax preparation service were paying percentage rent, it wouldn’t be real happy with a short year at the end of its lease term running from January to April 30 given that there is very little business the rest of the year.

Now, off to another issue – when should a tenant start cutting percentage rent checks to its landlord? Frankly, very often, even though a lot of leases call for monthly (interim) reporting of tenant sales, most don’t call for payment until after the end of each calendar year based on the annual reported sales. That’s probably not “fair” to a landlord, if “fair” plays any part in this equation.

On the other hand, when a lease calls for monthly payments based on use of a “monthly” sales breakpoint equal to 1/12 of the annual sales breakpoint, we think the pendulum swings too far in that direction. Similarly, although there may be better support for calling for installments of percentage rent payments based on the prior year’s sales (i.e., using the prior year’s sales as the basis for an estimate of sales for the next year), we think that is not what the percentage rent concept should envision.

If Ruminations were King, and that thought invokes that old saying about one-eyed Jacks, we would issue the following edict: once a tenant’s sales in the year pass the sales breakpoint number, it starts paying the resultant percentage rent. Yes, pay monthly for incremental sales over the sales breakpoint (less what may have previously been paid for that year).

Having written all of that, we now pose a thought often lost among those of us who write about the perfect or the hypothetical. Sometimes you just ought to forget about striving for mathematical perfection. Sometimes, it isn’t worth the effort to make the parties expend a whole bunch of administrative effort doing all of this accounting. Under the KISS principle, maybe the incremental benefit of getting one or two or three year-end checks as contrasted to waiting until March 1 for one large check just plain isn’t worth it. Yes, there is a “cost of money” concept and there is a “lost opportunity” concept, but “concepts” apply equally to pennies and millions. If it’s going to be millions in percentage rent (Ha Ha), there is a value to getting the money earlier. If that’s not the expected scale, keep in mind that it may not be worth the effort to create accounting nightmares on both ends. It’s not a big deal either way, and Ruminations is a little equivocal about leaving this paragraph in today’s blog posting.

Over the years we’ve said a few things about the practice of just copying a clause from a decades-old lease form that was, itself, copied from a decades-old lease form and so on. Today that manifests itself in the following question. When was the last time you saw a cash register (what’s that, you ask?) that retained a printed sales tape? So, why do we copy that requirement into a 2014 lease? Retailers use sales terminals that keep digital, not tangible, records. If you want to see a cash register, tune into Pawn Stars or Antiques Roadshow. Look at your form lease’s “tenant shall keep…” “language” and then “get with the times.”

Yes, there will be and should be “audit rights.” But, let’s recognize that real retailers with lots of employees, not just family members, will want their sales recorded. They are more concerned about theft than they are about trying to hide from the landlord’s search for percentage rent. There will be books and records like the kind that businesses use to run themselves. There will be tax returns. There will be sales tax reports. Basically, if you think a tenant operates as a cash business, you aren’t going to figure out the sales anyway. Ruminations, itself, would not disparage particular types of retailers or even draw stereotypes, but there is some basis behind the belief that small food operators, such as diner operators, have a hard time keeping track of their receipts or payrolls. There are other stereotypes as well. Perhaps it is better to just plain get paid through minimum rent with tenants who might not be good at record keeping. Some even have trouble when it comes to reporting sales to the government. Basically, if you’re not going to receive percentage rent payments and you know you’ll never independently figure out a tenant’s sales, save a tree or two and forget about writing a Pulitzer Prize level percentage rent provision in the lease.

Now, (and lastly in keeping with last week’s promise that we’d only be sharing a limited number of thoughts about percentage rent), how accurate does anyone think the “carve-outs” or “exclusions” from gross sales will be calculated, even for totally honest reporters? So, again, we suggest the use of a “blanket” adjustment to gross sales in lieu of a long list of items that would be subtracted from the overall sales number. Of course, collected sales taxes would be a separate exclusion (because if the sales tax rate eventually grew from 5% to 7% over the course of the lease, a blanket “percentage allowance to gross sales (of, say, 10%) would not cover the incremental 2% harm. And, sales tax is paid over to the government. So, the amount paid can be found on a single government report form and the “cancelled check” (another anachronism) can be viewed.

If any reader has any additional or different thoughts, please throw your hat in the “comment” ring by using that feature immediately below.

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Comments

  1. Ira, the way breakpoints for partial years are computed, it is assumed that the sales in any month are the same as in any other month, an assumption everyone knows is not true. Thus, here’s another way to apportion the breakpoint for a partial lease year. A client of mine earned 63% of its sales during the 5 months of August through December. So, 63% of the annual breakpoint should be used for that partial lease year. When writing the lease, the parties can use artificial, temporary estimates supplied by the tenant (e.g. 63%) Then at the end of the first 12 months from the rent comment date,, the actual sales for those same months can be trued up and the proper proportion applied. This balances out at the end of the term with the tail end short year. Another solution, avoid the problem altogether by having a percentage rent “lease year: equivalent to a “term year”, thereby eliminating any short years.

  2. Dan Loewenstern says:

    Ira,

    An alternate method of partial year’s I’ve used is to create an artificial first or last year of the first or last 12 month period’s sales, and then multiply by the number of days in the partial year. For example, a store opening on 11/15 would create an artificial first year running from 11/15 through the following 11/14. If the first year’s breakpoint is hit over those 365 days, the Tenant would pay 46 (15 in November plus 31 in December) /365ths of the Percentage Rent due for that artificial year. This avoids the problem in your suggested concept of creating an artificially long year with 2 holiday periods.

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