What’s The Percentage In Paying Percentage Rent?

First, we’ll define “heresy”: dissension, dissent, nonconformity, heterodoxy, unorthodoxy, apostasy, blasphemy, freethinking – opinions profoundly at odds with what is generally accepted. Now, we’re going to write a few things about “percentage rent,” beginning with a heretical view, “Why should a tenant pay percentage rent in the first place?”

Mind you, we’re not talking about a deal where the entire rent is a function of a tenant’s sales; we’re talking about the usual situation where the tenant has to pay rent even if it sells nothing. [We know of a mail order merchant maven who regales everyone with a story about the biggest flop item he ever handled. The story he tells is that he sold three units and got six returns.] Why should a landlord be a partner on the upside, but not on the downside? Ruminations has written about the concept that, in exchange for money paid as rent to a landlord, the tenant gets exclusive possession of the premises until an agreed-upon date. It’s like buying the premises with the obligation to re-convey it on that date. Further, think about a fairly common lease provision: “landlord and tenant are not partners, joint venturers, etc.”

OK, that’s the theory and we think it is a pretty valid one. On the other hand, we know that some markets price space on the presumption that there will be a percentage rent provision. Even though Ruminations typically shows little respect for customs that many of us have come to treat as if they were the “law,” regular readers know that one of the few parameters Ruminations respects is the “marketplace.” For that reason, we don’t think that writing about a smattering of percentage rent issues today is inconsistent with our just displayed, pretty negative attitude about percentage rent arrangements. Mind you, we’re only going to skip rocks across Lake Percentage Rent and, in doing so, only hit some of the high points.

First, here are a few words about the “natural break.” For the few readers who haven’t figured out what such a thing might be, let it rip. The “natural break” ties into the concept of “minimum rent,” the least a landlord will get paid. Let’s say (for a pure percentage rent deal) that the tenant is expected to pay rent equal to 5% of its annual sales. Where there is a “minimum rent” in the lease, it means that even though 5% of the tenant’s sales come to less than that minimum rent, it is the minimum rent that has to be paid. [That’s why it is called a “minimum.”] So, let’s show an example and a little math should lead us to understanding the “natural break.”

Assume a minimum rent of $120,000 a year. If there were no minimum rent and all that the tenant paid was 5% of its annual sales, once the tenant’s sales reached $2,400,000, it would be paying $120,000 for our hypothetical year. Yes, 5% of $2.4MM is $120,000. That happens to match the minimum rent for that lease. For every dollar of annual sales above $2,400,000, the tenant would pay an ADDITIONAL nickel. That means, naturally, that once the tenant’s sales break through the $2.4MM point, it has to pay more than the stated minimum rent. Combine “natural” with “break” and then add the word, “point,” and you get the “natural breakpoint” (of $2,400,000).

There is no “law” that commands people to use a natural breakpoint, though the “market” assumption is that it will be used unless otherwise agreed-to. Landlords and tenants are free to negotiate any sales threshold above which the tenant will begin to cut additional checks.

We shudder whenever we see a lease use the term “natural breakpoint” and not set forth a “formula” that can be used. The concept of percentage rent with a “natural breakpoint” is that the tenant will pay “X%” of sales each year, but not less than the “minimum annual rent.” There are lots of ways to write the formula, but the actual provision has to fit in with the way the rest of the lease is written. So, we’re not going to include a sample provision in this blog posting.

We’d like to add a couple of notes, however, about how a formula can be written, again by use of an example. Let’s say that the percentage rent year is the calendar year, but the annual minimum rent changes mid-year. Determining the “natural breakpoint” for that calendar year is easy. Use the aggregate annual minimum rent for that year and then divide it by the percentage you are using for rent purposes (expressed as a decimal). Let’s say the annual minimum rent at the beginning of the year was $60,000 (or, $5,000 a month). Then, let’s say the annual minimum rent goes up to $72,000 (or, $6,000 a month) on April 1. Combined, that’s $15,000 through March and $54,000 through year-end, for a total of $69,000. With a percentage rent level of 5%, you divide $69,000 by 0.05 and you get a natural breakpoint of $1,380,000.

Said in words, “the Sales Break Point for any given calendar year is the total annual minimum rent payable for that calendar year divided by 0.05.”

Now, for our next little tidbit – what should be meant by “sales,” the number used to multiply against the agreed-upon percentage figure? Our basic principle is that it should mean what the store (not some other store) actually realizes as revenue, and also not what it merely books as “owed to it.”

What’s the distinction Ruminations is making between cash in the pocket and promises in the wind? That’s rhetorical. Sales should not include uncollected accounts; unpaid accounts receivable; or credits, discounts, adjustments or allowances (because that’s revenue, just a different way to set the selling price). We’re not even sure that a tenant’s sales shouldn’t be net of credit card company charges. Arguments could be made that credit card company charges are “expenses” just as employee wages are salaries. We think the better view is that if a retailer gets only 97 cents in its pocket, that’s what its “sales” are. The way it works is that the credit card company gets the whole dollars and pays 97 cents (or something in that range) to the retailer.

If the matching revenue was previously included within a tenant’s sales, then reversed credit card charges, bad checks, and refunds given should be subtracted from those sales (or from sales otherwise recorded in the period when those things happen). So should refunds or credits given to resolve customer complaints.

In addition, there are certain items sold at very low margin or at cost with the intention of inducing customers to spend money at the store. An example might be postage stamps. It seems indecent for a tenant to sell stamps at cost and then pay a landlord 5% of that revenue. Similar situations of no or very low profit margin items might be delivery charges, gift wrapping or alterations. Every business has such items. These are often priced, not to make a profit, but as a sales inducement, with the “real” cost embedded in the selling price of the items to be shipped or wrapped (the revenue from which would be included in “sales.” In the same category would be sales to employees or to employees of subtenants or concessionaires (if done with a genuine “employee” discount) and vending machine sales where the vending machines are in employee areas.

Another “no profit” item is sales tax. Retailers are only agents for the government. Taxes should not be included in “sales” even though they go into the cash register.

There are more items that could be caught up in a “broad” definition of sales, but shouldn’t be included. Some examples are revenue presumably recorded in connection with transfers of merchandise between the store and affiliated stores or warehouses or revenue “recognized” in connection with transfers or returns of merchandise to vendors, suppliers or manufacturers.

Certain business arrangements can be problematic, such as the presence of a leased department within a store. For example, a department store might sublet space to a “brand” manufacturer and collect a concession fee from that manufacturer as well as a percentage of the sales that manufacturer might garner from its “kiosk” or “area” within the store. If one includes the manufacturer’s (concessionaire’s) retail sales proceeds as part of the tenant’s sales, to also include the “cut” given to the tenant or the “rent” paid by the manufacturer would be double counting. The same situation comes up when a third party owns and services vending machines in the store and the tenant only gets a percentage of the what shows up in the coin box.

And, in some jurisdictions, you can’t or shouldn’t pay a percentage rent on some goods or services. That might be liquor or it might be what a physician collects at an in-store clinic.

One big bone of contention between landlords and tenants is whether and how “internet” sales are to be treated. This is a just a special case of the question of whether items, bought at or from a source other than the store, but picked up at the store, are truly “sales.” We think not. We think that if a landlord has any right to percentage rent, it is because it has created an environment that brings business to most stores at that property. That’s an “extra” value brought to the table by a landlord beyond the landlord’s mere brick and mortar. If a tenant leased space just to serve as a customer pick-up location for 20 different retailers, no one would expect it to pay percentage rent based on the [unknown to it] value of what was in those boxes. The value added when a tenant is one of many at a property is that the location draws customers to SHOP. A shopping center is a form of marketing and advertising organized by a landlord. There is a synergistic relationship among all of the retailers located at a shopping center.

When a sale is made at one location because of its salespeople and displays, that’s where the sale is made, even if the item or items are shipped or delivered to the customer’s home or office – or even to another of the owner’s stores for a customer’s convenience. In Ruminations’ view, landlords should be happy, happy, happy that a store’s customer, having purchased an item on-line, from home or office, then visits the store to pick up the merchandise. Shopping centers can’t live on business from hermits. Getting people to stores is called “traffic.” It’s why the pick-up area is at the back of the store so that customers are required to pass through aisles and aisles of seductive merchandise (and pass by the other stores while going to “pick-up” at the actual merchant). That’s why you pass through the casino to get to the hotel registration desk. That’s why the prescription counter is at the back of the drugstore requiring customers to view the front-end merchandise on the way. To us, although the internet sale wasn’t made at the store, additional sales might be. For those and other reasons, we think it is counterproductive to try to include “internet” and “picked-up” merchandise in “sales.”

If you read a lot of leases, you’ll see a lot of different exclusion or “carve-out” lists. What you won’t see is something Ruminations would like to see – cut out all the lists and define sales as 90% of what the store actually receives from customers. Pick a different percentage if you will, but don’t make accountants or bookkeepers rich. If a customer (not another other store) paid for something and by accounting standards the amount paid is called “sales,” use that number and just plain apply an “adjustment” or “fudge” factor to encompass the employee discounts, the no- or low- profit items, the bad check charges, etc. That’s the accounting concept used when, on an accrual basis, an allowance for bad debts is applied to gross sales. Credit should be given for sales tax paid to governmental authorities. At the end of the day, the whole concept of paying percentage rent is an artificial contrivance, so to apply an artificial adjustment factor would be entirely consistent with the percentage rent scheme.

Now, off to another little twist – what to do about the “short” year. That comes up if percentage rent is calculated on a calendar year, but the tenant doesn’t open for business until November 1. Basically, we don’t like the simple approach most leases take, but readers will need to wait until next week to learn why. Also in next week’s blog posting, we’ll talk about the timing of payments and some administrative percentage rent-related items.

As always, we invite readers to add their thoughts to the discussion we hope we are triggering today. That can be done by adding your comment in the box provided below and then “clicking.”