With Black Friday and the holiday shopping season approaching, retailers hope for sales revenues that will make them profitable in 2015. Landlords who receive percentage rent from retail tenants share their hope.
Percentage rent clauses in retail leases encourage a symbiosis between shopping center landlords and their tenants. Landlords have incentive to promote their properties and to cultivate tenant mixes that increase customer visits and tenants’ sales. When tenants’ gross sales reach a certain level known as a “breakpoint,” tenants pay a percentage of sales revenue above the breakpoint to the landlord as rent. The breakpoint and the percentage are both negotiated based on the parties’ relative bargaining power. Percentage rent raises several issues.
Natural breakpoint. Although breakpoints are negotiable, percentage rent leases often settle on the “natural breakpoint,” which is the amount of sales equal to the tenant’s annual base rent divided by the applicable percentage. For example, if a tenant pays $200,000 in annual base rent and its percentage rent figure is 5 percent, the natural breakpoint is $4 million ($200,000 divided by 0.05). In this example, a tenant generating $5 million in gross sales in a given year pays percentage rent of $50,000 ($5 million less $4 million, times 0.05), plus its $200,000 annual base rent.
Exclusions from gross sales. Not all tenant revenues are included in the percentage rent formula. Sales taxes are an obvious exclusion, as are revenues from returned goods and sales where tenants pay refunds to customers. Sales of tenant’s fixtures and equipment (instead of inventory) and sales from tenant vending machines reserved for tenant employees are also properly excluded. Shipping and finance charges are often removed from the equation. Tenants offering employee discounts will want to exclude those sales as well, but landlords often limit this exclusion.
Continuous operations and radius clauses. Imagine a scenario where a tenant has made ample percentage rent payments for years, but suddenly its percentage rent payments cease. Upon investigation, the landlord finds that the tenant’s once thriving store is now abandoned and gathering dust. Perhaps tumbleweeds languidly roll about the parking lot. Meanwhile, at a rival shopping center, the tenant has opened a new store where delivery trucks queue to unload inventory and hordes of customers merrily stuff their minivans with merchandise. To address this potential problem, landlords require tenants to open for business during certain hours daily (often penalizing them if they do not) and forbidding tenants from operating other stores within a certain radius of their shopping centers.
Audit rights. During nuclear weapons negotiations between the United States and the Soviet Union in the 1980s, President Ronald Reagan warned American negotiators to “trust, but verify.” This proverb applies to percentage rent leases. Tenants are expected to furnish landlords with sales reports, and landlords reserve the right to audit tenants’ records to verify that sales are not understated. If an audit reveals understated sales beyond a negotiated threshold, the tenant must pay the shortfall, audit costs, and financial penalties. Tenants should seek time limits on landlords’ audit rights, to avoid the inconvenience of maintaining sales records over extended periods of time.
Online sales. Online sales throw a monkey wrench into the traditional approach to percentage rent. Difficulties can arise where customers visit brick and mortar stores, learn that desired goods are not in stock, and allow store clerks to order the goods online from other stores. A spectrum of different kinds of online sales are variations on this theme. Some general rules are helpful here.
First, if an online sale is fulfilled from inventory on hand at a given store, it counts toward the gross sales of that store. Second, if an online sale is ordered at a given store but is fulfilled from an offsite warehouse, the sale should be included in that store’s gross sales. However, where a sale is made at one store, but fulfilled at another store, the sale should only be included in the gross sales for one of the stores. In other words, tenants should not have to pay percentage rent twice on the same transaction.
Online sales present fertile areas for negotiations between landlords and tenants.
Percentage rent considerations loom large in the retail industry every holiday season. While visions of sugar plums dance through children’s heads, shopping center landlords dream of tenants surpassing percentage rent breakpoints. But unlike children, who find out in December if their holiday expectations are met, landlords must wait for tenants’ sales reports in late January to learn of their holiday rewards.
Christopher R. Vaccaro is a partner at Dalton & Finegold LLP in Andover. His email address is cvaccaro@dfllp.com.
