Get Right to End Lease or Raise Rent If Percentage Rent Falls Below Expectations
Landlords who rely on tenants' inflated sales projections are apt to get burned.
Signing percentage rent tenants to long-term leases exposes you to risks of underperformance. Under standard leases, you won’t have any remedies when percentage rents turn out to be below expectations other than waiting for the lease to expire. However, experts say that there’s a leasing strategy you can use to avoid getting locked in: Negotiate for a clause that gives you the right to take action in the event that the tenant’s percentage rent payments over a stated period of time fall short of expectations.
Getting the right to terminate the lease is the most potent remedy if the retail rental market is strong. However, weaker market conditions and/or lack of bargaining leverage over the tenant might require you to compromise on remedies. One common solution is to allow the tenant to avoid termination by paying off the percentage rent shortfall by agreeing to pay a higher fixed rent over the remaining lease term. Here’s a look at the strategy and a Model Lease Clause you can use to implement it.
Landlords Suffer When Percentage Rent Tenants Underperform
Percentage rent leases split total rents payable between fixed rent and rent based on a percentage of the tenant’s sales calculated by multiplying gross sales by an agreed-to percentage stated in the lease. The higher the expected gross sales, the lower the percentage the landlord will need to make money on the lease. While high gross sales are a win-win, the percentage rent dynamics also give tenants an incentive to provide inflated sales expectations during lease negotiations.
Landlords who rely on these inflated sales projections are apt to get burned when reality sets in and percentage rent payments turn out to be significantly less than expected. But unless they’ve anticipated and made plans for this contingency, they may have no recourse. Being stuck with underperforming percentage rent tenants is particularly frustrating when the market is strong and there are other businesses that could take over the space at higher rates.
GET RIGHT TO TERMINATE LEASE
WHEN PERCENTAGE RENTS FALL SHORT
The ideal solution would be to have the right to terminate the lease because the tenant is underperforming on percentage rent. However, securing that right requires foresight and negotiation. Even if tenants are willing to grant you such a termination right, they’ll also want to impose restrictions. The ensuing negotiations will likely boil down to two crucial terms:
- The minimum amount of percentage rent that the tenant must pay to avoid triggering your right to terminate the lease, which we’ll refer to as the “make-or-break” amount or target; and
- The “test period,” or time over which you’ll monitor the tenant’s percentage rent payments to determine if they reach the make-or-break.
First Phase: Establish the Make-or-Break Amount
The make-or-break amount is typically calculated as a percentage of the total fixed rent that the tenant must pay during the test period—for example, 20 percent of the fixed rent over the first four years of the lease.
Step 1: Calculate total percentage rent expected over lease term. The starting point is to determine how much percentage rent you expect the tenant to pay over the entire lease term based on the tenant’s sales projections. Example: A tenant seeking a 10-year lease term projects average gross sales of approximately $500,000 per year over the course of the agreement. Percentage rent is set at 5 percent of gross sales. Total expected percentage rent over the lease would be $250,000—that is, $25,000 per year x 10 years.
Step 2: Calculate total percentage rent as percentage of total fixed rent over lease term. Having determined total expected percentage rent, compare it to what you expect to receive in total fixed rent payments over the lease term. Example: If the tenant in the above example will pay $1 million in total fixed rent over the 10-year lease term, the $250,000 in total percentage rent will represent 25 percent of total fixed rent.
Step 3: Use resulting percentage to set make-or-break amount. The resulting ratio between percentage and fixed rent over the entire lease term should also apply during the test period. Sticking with the example, the make-or-break amount would be 25 percent of the expected fixed rent during the test period, or $25,000 for as long as the test period lasts.
Second Phase: Establish the Test Period
The next phase is to negotiate how long the test period will last. The shorter the test period, the less time you’ll risk being stuck with an underperforming tenant. But also keep in mind that it takes time even for established businesses to get up and running in new space, and expect tenants to demand the longest possible runway. Where you decide to meet in the middle on test period length will depend on a number of factors, including:
Length of lease: The length of the test period should vary in proportion to the length of the lease. Thus, for example, a two-year test period may be:
- Too long for a three-year lease;
- Too short for a 10-year lease; and
- Reasonable for a five-year lease.
Tenant’s business: New and fledgling businesses typically need more time to attract customers and build a reputation than do national chains and other established businesses. At the same time, the former generally carry greater risks. So, you’ll need to take these dynamics into account when setting the test period.
Percentage/fixed rent ratio: Consider how much of what the tenant pays will be fixed, as opposed to percentage rent. The higher the percentage of fixed rent, the less vulnerable you are to lower than expected percentage rent payments. Example: You can probably afford to give a longer runway to tenants whose percentage rent payments are only 5 percent of fixed rent than you would to tenants with a 25 percent percentage/fixed rent payment ratio.
Third Phase: Consider Asking for Time to Exercise Termination Option
You don’t want to get locked in one way or another in case it turns out not actually to be in your interests to immediately terminate the lease of a tenant that misses the make-or-break target during the test period. Maybe the market has softened; or maybe the tenant is just getting its legs and seems poised to turn its business around. Instead of making lease termination automatic, you can maximize your flexibility by giving yourself a reasonable period—for example, six months—to assess the situation and make a decision on whether to terminate due to the tenant’s failure to reach the make-or-break target [Clause, par. a].
HOW TO NEGOTIATE A COMPROMISE
Don’t be surprised if tenants push back on giving you a termination option, experts caution. While acknowledging your right to some remedy for their falling below the percentage rent make-or-break during the test period, tenants may object that termination is too harsh, particularly if they invest a lot in preparing the space or marketing the business and now face the prospect of having to move out and start from scratch.
You can compromise by agreeing to give the tenant the opportunity to remain in the space after receiving your notice of termination by making certain concessions. The price tag to stay: Agreeing to eliminate the deficit between the make-or-break and the total percentage rent actually paid and accept an increase in fixed rent. This way, you’ll get the rent you originally expected [Clause, pars. b, c].
Example: A tenant falls short of the make-or-break amount of 25 percent of the total fixed rent during a three-year test period. To stave off lease termination, the tenant can agree to an increase in fixed rent, starting in year 4 and through the remainder of the lease term, equal to the make-or-break percentage of 25 percent. Thus, if the tenant’s original rent for year 4 was $100,000, it would agree to pay $125,000 in fixed rent during that year. Fixed rent for year 5 originally set at $110,000 would increase to $137,500 (25% of $110,000), and so on.
Get Right to Benefit If Tenant’s Sales Increase
Keep in mind that the make-or-break amount is just the minimum percentage rent you expected at the time you signed the lease. There’s a chance that the tenant’s sales will increase after it decides to stay at the higher rent. In that case, the higher rent might actually turn out to be less than the percentage rent the tenant would have had to pay under the original percentage lease clause. To ensure you benefit from this jump in sales, require the tenant to make up any such differences [Clause, par. d].
Example: A tenant paying percentage rent of 5 percent of gross sales misses the make-or-break target of 20 percent of fixed rent during the three-year test period of a 10-year lease. To avoid termination, the tenant agrees to pay 120 percent of its fixed rent for each subsequent lease year. In year 7 of the lease, the tenant pays $120,000 rather than the $100,000 amount set under the original lease. That same year, the tenant has $500,000 in gross sales. Under the terms of the original lease, the landlord would have been entitled to $125,000 (the original fixed rent of $100,000 plus percentage rent of 5 percent on $500,000 in gross sales). The landlord would then be entitled to an additional payment of $5,000—that is, the difference between the $125,000 the tenant would have paid under the original lease and the $120,000 paid as the concession to avoid termination after year 3.
Most tenants will agree to this offset, attorneys say, because it requires only that they pay what they initially agreed to pay when negotiating the original lease.
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