The following reviews the various methods of calculating percentage rental, and the administrative provisions pertaining to percentage rental payments by retailers under percentage rent leases.
Methods of Calculation
There are several different methods of calculating percentage rental for retailers. Payment of a specific percentage of gross sales with a guaranteed minimum rent is probably the most common. This method of calculation is generally effected by language obligating the tenant to pay "percentage rental equal to five percent (5%) of the tenant's gross sales less the minimum rental payable under the lease."
Another method of percentage rent calculation is to provide for a minimum rental with payment of a percentage of gross sales over a stipulated breakpoint or breakpoints. Language effecting a stipulated breakpoint would obligate the tenant to "pay percentage rental equal to five percent (5%) of all gross sales in excess of annual sales above the sum of One Million Dollars ($1,000,000)."
The stipulated breakpoint method for the purpose of calculating percentage rental can be dangerous when partial years are involved. This method, unless the lease provides otherwise, may allow the tenant to have gross sales at a rate greater than the break point for a partial year under the lease, and avoid paying percentage rent for that partial year, since the stipulated breakpoint is not exceeded for the short year.
In the event a stipulated break point is used to calculate percentage rent, the tenant may wish to insist upon a provision that reduces the breakpoint in the event the rental for the premises is reduced, e.g., in the case of a partial condemnation of the premises occupied by the tenant.
There is really no requirement that a stipulated breakpoint relate directly to a mathematical breakpoint for the calculation of percentage rental. Of course, the mathematical breakpoint is calculated by dividing the minimum rent by the percentage of gross sales the tenant is obligated to pay. For example, if the minimum rental for the premises is $50,000 per year and the tenant is paying 5% of sales, then the mathematical breakpoint is $l million. However, the parties could agree that the minimum rent would start at higher than $1 million, e.g., $1.25 million. This is sometimes called a "skip," since a portion of the gross sales against which percentage rent is calculated is "skipped", i.e., that portion between $1 million and $1.25 million.
The same result could be achieved by using a "split" percentage approach. The term "split" percentage deal comes from the use of two percentage figures, the first to calculate the breakpoint, and the second to fix the amount of percentage rent payable for sales in excess of the breakpoint. For example, in a "split" 4%/5% deal, the breakpoint would be calculated by dividing 4 percent into the minimum rental of $50,000 to yield a breakpoint of $1.25 million above which the tenant would pay 5 percent of gross sales as percentage rent.
Finally, sometimes tenants negotiate different percentage rates for increments of annual sales. For example, the tenant might agree to pay 5 percent on sales between $1 million and $2 million, and 4 percent on sales above $2 million. Frequently, this sort of agreement results from a compromise between a landlord who wants 5 percent of sales as percentage rent and a tenant who wants 4 percent of sales payable as percentage rent.
The last method of calculation is by far the least prevalent--it is the "straight percentage" or "percentage only" deal which obligates the tenant to pay solely a percentage of gross sales as rental with no fixed minimum rental. It is usually only used with major anchors for regional shopping centers or anchors for community shopping centers. Suffice it to say that substantial tenant leverage is required to obtain a straight percentage deal. The main nuance associated with this type of deal is the possibility of an implied operating covenant (i.e., a covenant to conduct business continuously in the premises) for the tenant in many jurisdictions, unless the lease provides expressly otherwise. Courts may imply this sort of covenant since the landlord will receive no rent if the tenant ceases to operate, even though the tenant has the continued occupancy of the premises.
Definition of Gross Sales and Exclusions
Generally, landlord-oriented percentage rent leases have an expansive definition of gross sales. Such sales are typically calculated by utilizing "the actual sales price of all goods, services and merchandise sold, delivered or licensed in the premises by the tenant, or by any subtenants or concessionaires, whether they are made for cash or on credit." Tenants generally seek relief from such broad definitions by proposing to exclude a number of items from the base against which percentage rental is calculated. Common exclusions include:
- sales or excise taxes payable the tenant to taxing authorities;
- proceeds from the sale of gift certificates until redeemed for service or merchandise;
- labor charges for incidental services in the premises, e.g., charges for Christmas wrapping;
- all credits and refunds given or made to customers for returns of merchandise;
- all sums received in settlement for lost or damaged merchandise;
- sales of machinery, equipment, trade fixtures not made in the ordinary course of the tenant's business;
- sales to employees at a discount (often with a maximum amount for such sales);
- incidental receipts by the tenant (e.g., vending or stamp machine receipts, receipts from public telephones, proceeds from the sale of money orders, and receipts from video games, although frequently landlords are not willing to exclude video game revenue since it can be substantial).
- charges paid directly to credit card issuers.
Record Keeping and Rights of Audit
Frequently, provisions in the lease requiring the tenant to maintain records pertaining to percentage rental are onerous from an administrative point of view, especially for chain store retailers. National tenants frequently balk at rules requiring percentage rental records to be kept on the premises of the store rather than at the home office for the retailer. Further, national tenants frequently object to language which requires them to retain sales slips, bank deposits, tapes from cash registers, or other point of sale reports from business machines located on the premises. In addition, many percentage rent provisions require the chief financial officer of the tenant to certify percentage rent reports submitted by the tenant. Generally, national tenants will not agree to such certification requirements, but will agree to furnish sales reports to the landlord with a reasonable amount of detail.
Other questions pertaining to record keeping for percentage rental include:
- Are separate records required for subtenants and concessionaires?
- Is the tenant required to submit backup data for statements of percentage rent if requested by the landlord?
- Must the tenant furnish copies of audits to the landlord that the tenant has performed or copies of sales tax returns to verify gross sales?
- Can the landlord audit the tenant's records concerning gross sales and is there a cutoff period by which this audit must be performed?
- Is there a "penalty assessment" that is payable in the event the tenant has underpaid percentage rental as disclosed by an audit?
- Is the tenant required to pay the cost of an audit if the sales are found to be understated by a certain percentage, e.g., three percent?
- What is the retention period during which the tenant must retain sales records for audit by the landlord?
Timing of Payment
The mechanics of payment of percentage rental really are cash flow issues between the landlord and the tenant. The landlord wants percentage rental paid as soon and as often as possible, and the tenant wants just the opposite. Generally, tenants try to modify percentage rental provisions to provide for payment of any percentage rental due within thirty days following the end of the lease year. Landlords often dislike lump sum annual percentage rental payment because of its adverse impact on cash flow. Frequent compromises on the manner of payment include:
- payment semiannually within thirty days; or
- payment on a quarterly basis within thirty days; or
- payment monthly after the breakpoint is exceeded by the tenant's gross sales within fifteen days following the end of the month.
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