What’s The Difference Between Percentage Rent And Percentage Escalation Clauses?

Sep 18, 2014

What Exactly Is Percentage Rent?

A common clause in leases with commercial tenants is the PERCENTAGE RENT CLAUSE. Rather than paying a set fee per month, percentage rents can vary depending on how much money the tenant makes.

Percentage rents are common for both retail and office commercial income properties, and can vary depending on the type of business using the space. Tenants pay a base rent, which is a set amount of money per square foot, multiplied by the number of square feet.

However, the tenant and the owner also agree that if sales for the tenant reach a certain amount, then the tenant will be obligated to pay a percentage of the gross sales of the business. The point that the tenant will be obligated to pay a percentage of their profits is called the breakout point.

There are two types of breakpoint:

  • natural and
  • artificial.

In order to calculate the natural breakpoint, simply divide the base rent by the percentage, which can differ depending ont the type of property. The answer will be the natural breakpoint; in other words, the tenant will be obligated to pay a portion of their gross sales once their profits have reached that number.

natural breakpoint calculation

For example, if the property is a supermarket, the percentage is usually 10%. If the base rent is $60,000 per year, then you would divide $60,000 by 10%, which would give you $600,000. That would mean that the supermarket tenant would be obligated to pay a percentage of their gross sales after profits reached $600,000.

Although percentage clauses are fairly common, the actual percentage can be NEGOTIATED. For example, some landlords may decide on an arbitrary breakpoint – also called an artificial breakpoint- but may use a number so high that the breakpoint is never reached.

Or, tenants can negotiate that gross sales must be maintained for an extended period, for a year, for example, before the percentage clause kicks in. Other tenants might negotiate for a higher base rent with a higher breakpoint, so that they have time to stabilize their business before paying the landlord “commission” on their gross sales.

What Actually Are Percentage Escalation Clauses?

Percentage Escalation Clauses are similar to percentage rent clauses in that they too operate from a FIXED BASE RATE. However, instead of tying rent increases to an increase in gross sales, increases are based on the owner’s anticipated increase in operating expenses for the commercial real estate investment property. Thus, the tenant is required to pay their share of the operating expenses, their share usually being determined by the amount of space they occupy in the building.

An additional component is also sometimes added to the lease, known as the “gross up clause.” This clause adds that if the building’s occupancy rate is lower than a certain amount, the remaining tenants will need to carry the difference not being paid due to the higher vacancy rate.

As an owner, the tenant may require you to audit your operating expenses, so make sure to thoroughly document expenses like:

  • cleaning,
  • utilities,
  • trash removal,
  • electricity,
  • landscaping,
  • repairs,
  • maintenance.

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