The holiday shopping season is nearly upon us, and with it, one of the most important times of the year for the retail industry. Long lines at merchant registers and crowded shopping malls during the holidays keep many retailers in business through slower times of the year and help pay the rent for their landlords.

After a prolonged period of diminished retail sales and high vacancy rates at shopping centers around the country, the retail industry is starting to see signs of a rebound. Still, retailers and landlords should be watching this holiday shopping season closely to see how the recent explosion of on-line shopping will impact retailers and their commercial landlords.    

“Percentage rent” is a familiar concept to retailers and their landlords and has long formed a large part of the business arrangement between commercial landlords and their retail tenants. In a lease arrangement that includes percentage rent, a landlord may negotiate a relatively reduced base rent for the chance to have some “skin in the game” by agreeing to take a percentage of the tenant’s revenue, or gross sales, from their store once that revenue exceeds a certain threshold amount.

Tenants appreciate this arrangement because they only pay percentage rent if they are doing well and their revenue exceeds that negotiated threshold level.

Landlords appreciate this model because it compensates them for the costs they incur creating and maintaining successful shopping centers with amenities, such as food courts and open spaces. If a successful shopping center drives foot traffic to individual tenants and increases their sales, tenants are often willing to compensate landlords for their part in driving that foot traffic. The concept really is a “rising tide lifts all boats” model, in which landlords and tenants work as partners.  

Online Shopping’s Impact

The explosion of on-line shopping throws a wrench into this scheme. With more people making their purchases from these same retailers on-line, and more retailers encouraging customers to place orders on-line, how will retail leases with percentage rent provisions be affected? Many of these percentage rent leases are carefully crafted to limit what types of sales are counted toward the revenue in which a landlord can share. Often the way this is limited is by defining the sales as only those “made from the store.”  The question to consider: If a large percentage of a store’s sales are made on-line, can or should those sales be treated as made from, or initiated in that store, such that the landlord will be entitled to a percentage of such sales?

It is clear that out of stock items unavailable during a customer’s visit to a store, but ordered at the store and delivered directly to the customer’s home should be counted toward gross sales at that store and counted toward the percentage rent calculation. Similarly, online sales made at a computer terminal in the store or made at the customer’s home and picked up at the store should also be counted. It becomes much less clear when a customer never sets foot in the store itself when placing their order or receiving the goods. It may be very difficult for a landlord to claim they should be entitled to a percentage of an online sale made by a customer in their home where the merchandise is then delivered directly to that customer’s home.  

As traditional retail stores work to accurately account for online sales with their landlords, another issue has recently emerged. Traditional online only merchants like Amazon are starting to see the benefit of a brick and mortar presence as a way to market their business and may open physical locations soon. The question of percentage rent may become even more difficult to account for when the store front is really just a marketing device to drive customers to company websites.

A thoughtful balance must be found. Landlords need to be properly compensated for the sales they are driving to retailers. At the same time, from the tenant’s perspective retail leases will need to be drafted carefully so that sales having nothing to do with a particular store are not included when calculating percentage rent. If this balance is struck properly, these landlord/tenant partnerships will be well positioned for success in the rebounding retail and commercial real estate markets.

Geoffrey Smith is an attorney in the Real Estate Department of Boston law firm Sherin and Lodgen LLP. Email: ghsmith@sherin.com