Guest Post: Beware These Pitfalls of Percentage Rent Leases February 17,2020
By David Reeves, Messner Reeves LLP
Landlord: "OK, I will accept your reduction to the proposed base rent, but we need to add a percentage rent component. Let’s call it 7% over a natural breakpoint.”
Tenant: “What does that mean?”
Landlord: “Well, your annual base rent is $70,000. Dividing that amount by .07 results in a breakpoint of $1,000,000. If your gross sales exceed that amount, you will pay me 7% of the overage as additional rent.”
Tenant: “Sounds reasonable. If I hit $1,000,000 in sales, it’s all gravy.”
Landlord: “Great! My attorney will prepare the Lease draft. It is a little more complicated for percentage rent deals, as I’m sure you’ll understand.”
As in the above example, many Landlords require or propose a percentage rent structure as part of a restaurant lease, which means that the Tenant must pay to the Landlord a portion of the profits generated from the Tenant’s business. A Tenant may not appreciate the complications that arise from this type of arrangement.
When a Landlord has a defined financial interest in the operation of the Tenant’s business (by virtue of a percentage rent clause), the Landlord will insist that the Lease be written to protect that interest. Some of the lease terms impacted by a percentage rent structure are the following:
- Radius Restriction. The Landlord will insist that the Tenant not open a competing store within a defined radius, so as to protect against dilution of sales.
- Conduct of Business. The Lease may include certain standards regarding operation of the business, such as a requirement that the restaurant be fully stocked and staffed at all times, and a prohibition against changing the menu without Landlord’s consent. The Lease may also dictate the manner in which the business shall be advertised, and a minimum amount to be expended by the Tenant.
- Hours of Operation/Continuous Operations. The Landlord will insist that the Tenant maintain certain minimum hours, to maximize sales. The Tenant will be prohibited from “going dark,” meaning that the Tenant may be required to continue operating an unprofitable restaurant or risk a default under the Lease.
- Recordkeeping, Reporting and Review. The Tenant will be required to maintain detailed records of gross sales and exclusions therefrom. Tenant will be required to report sales on a periodic basis. The timing of such reporting is negotiable, but most Landlords require monthly reporting. The form and substance of such reports will vary, but may require extensive detail as well as officer certification. A Landlord may also require that the Tenant make estimated percentage rent payments based on gross sales. The Landlord will insist upon audit rights.
PROTECTING THE TENANT
The best way to protect against the issues inherent in percentage rent Leases is to avoid that structure altogether. That may entail paying a higher base rent, or making other financial concessions.
If the Tenant is forced to agree to percentage rent, or believes that such a structure is important to the Tenant’s success, it can still protect itself against potential liabilities by careful negotiation of the Lease provisions.
- Radius Restrictions. A radius restriction will be the unfortunate reality in almost all percentage rent Leases, and this clause should be diligently reviewed. Restaurant operators with multiple concepts need to ensure that a different restaurant concept is not accidentally impacted by a radius restriction. Existing restaurants should be excluded. A Tenant may also ask the Landlord to give Tenant exclusive use rights for any properties owned by Landlord within the restricted area.
- Operations. Tenants should carefully negotiate all provisions of a Lease that dictate the manner in which Tenant operates its business. A Tenant should have the right to determine its own hours of operation, advertising, pricing, and menu, within reason.
- Reporting. The Tenant will want to report gross sales as infrequently as possible, to reduce administrative burden. Ideally, a Tenant would negotiate for annual (one-time) reporting, with the report to include payment of any percentage rent owed for the prior year.
- Payments. Tenants should resist any lease clause that requires percentage rent to be paid on an estimated basis, especially where the Tenant’s business is seasonal. As an example, consider a restaurant in a ski area, with a Lease where the annual breakpoint is $1,200,000, and the monthly breakpoint is $100,000. This restaurant is likely to have very high sales January through March, in excess of the monthly breakpoint, and lower sales during mud season and the summer months. If the restaurant is required to pay percentage rent on an estimated basis, it will have paid a substantial amount to Landlord during the first quarter of the calendar year but may never actually reach the annual breakpoint.
- Exclusions. The Lease should provide a list of items that are excluded from gross sales. A Tenant should seek to exclude items which make little or no profit (such as employee meals or promotional giveaways), amounts Tenant does not retain or actually collect (such as sales and use taxes that are paid directly to the applicable taxing authority), and sales generated from something other than Tenant’s restaurant operations (such as the sale of outdated FF&E).
If you have questions about a Percentage Rent Lease, or any other terms of your lease, get in touch with us at Messner Reeves. CRA members referred in by the CRA receive 15 minutes of free advice, and a discounted rate on additional work. Call the CRA offices at 303-830-2972 or email firstname.lastname@example.org