A percentage lease is an agreement in commercial real estate where the tenant pays rent plus a percentage of their earned business revenue.
This type of lease is frequently used for commercial tenants, so it’s a must-know for real estate professionals. Students looking to understand how percentage leases work before the exam must learn from trusted sources. As a real estate professional with years of experience, I’m here to share all the knowledge you need on this vital topic.
In this post, we’ll define percentage leases, give examples of how they work, and discuss their pros and cons. Keep reading for a complete breakdown of this critical term!
What Is a Percentage Lease?
A percentage lease is an agreement where the tenant pays rent plus a portion of their business profits. In this type of lease, the landlord benefits from the tenant’s success.
Percentage leases are standard in commercial real estate, particularly in retail. If a tenant is renting a space for their business in a multi-tenant property, the owner may have them sign this type of lease.
Examples of properties where a retail tenant may agree to a percentage lease include:
- Shopping malls
- Shopping centers
- Any multi-tenant retail space
What Terms Are Covered in a Percentage Lease?
There are three important terms that landlords must cover in a percentage lease:
- Base rent
- The break-even point
- Percentage rate
The base rent is the price tenants pay to occupy a rental space. The square footage of the property typically determines the rent amount. No matter how much the tenant earns in revenue, the rent price is guaranteed and unchanging. Even if the tenant makes no money from their business, the landlord will collect the rent costs as a bare minimum.
The Break-Even Point
The break-even point, also called the breakpoint, is the income a tenant earns before paying a percentage of their sales to the landlord. Landlords typically identify the break-even point as the point where the percentage rent is equivalent to the base rent.
The percentage rent is the amount a tenant must pay from their gross sales to the landlord. The percentage rent varies from lease to lease, but is typically a flat percentage above the break-even point. Both the landlord and tenant must choose a percentage rent that works for them.
For example, the landlord and tenant may agree that the percentage rate will apply to 8% of gross sales above the breakpoint. This means that after the tenant’s business earns the amount defined in the breakpoint, they pay 8% on all other profits.
What Other Terms Should a Percentage Lease Include?
Like any commercial lease, a percentage lease agreement should also cover the following terms:
- Names of tenants occupying the property
- Property description
- Occupancy limitations
- Length of the term
- Security deposits
- Maintenance fees
- Legal access rights
- Illegal activity restrictions
- Disclosures and restrictions
Example of a Percentage Lease in Real Estate
Say that Camille owns a clothing store and wants to rent a space for her business in a mall.
Camille signs a percentage lease with the landlord, agreeing to pay $4,000 rent for a space at the mall. Per the agreement, she must also give 7% of her profits after earning a breakpoint of $8,000.
This is a typical example of how a percentage lease might work in the retail market.
Pros and Cons of a Percentage Lease
Before signing an agreement, tenants and landlords should know the advantages and disadvantages of percentage leases. Let’s discuss some of the pros and cons of this type of lease below.
A percentage lease is attractive to tenants because it requires paying lower base rent. Landlords have a vested interest in the tenant’s business, so they will likely provide maintenance and other services. It is also more likely that the tenant’s business will be in a good location, like a mall or shopping center.
The downside for tenants is that they may have to negotiate to get the best terms. Landlords naturally try to set terms that favor themselves, so tenants must know how to haggle. Another downside of a percentage lease is that tenants cannot keep all of their profits. They are required to give a percentage of their earnings to the landlord.
A significant advantage of a percentage lease for landlords is that they get a portion of their tenant’s earnings. As long as the business is doing well, the landlord will make passive income without doing anything extra.
One disadvantage of a percentage lease for landlords is that they have to charge a lower base rent. If a tenant’s business is not doing well, landlords will not make as much money from this lease. It also takes landlords more time to make money with percentage leases, as the tenant must reach the breakpoint before they can take any earnings. Landlords also have to worry that the tenant is not accurately reporting their income.
Check out this table for a clear breakdown of the pros and cons of percentage lease agreements:
|Pros of a Percentage Lease for Tenants||Cons of a Percentage Lease for Tenants||Pros of a Percentage Lease for Landlords||Cons of a Percentage Lease for Landlords|
|Base Rent Is Lower||Negotiating Problems||Percentage Yield||Base Rent Is Lower|
|Landlord May Provide Maintenance Services||Cannot Keep All Business Profits||Tenant is Motivated to Earn More Profits||New Leases Take Time to Make Money|
|Good Location||Can Choose Which Businesses to Rent to (Strategic Leasing)||Negotiating Problems|
|Tenant May Report Inaccurate Sales|
|Business May Not Do Well|
How to Calculate a Percentage Lease
There are three variables landlords look at when calculating percentage leases:
- Percentage rent
- Gross sales
- Square footage of the rental property
The equation for calculating a percentage lease looks like this: (Percentage Rent X Gross Sales) / 12 = Price Per Square Foot
Negotiating a Percentage Lease Agreement
According to Nolo, tenants and landlords should negotiate the terms before signing a percentage lease.
A tenant may have little room to negotiate the terms in a percentage lease agreement. However, they should still try to get the best possible deal. A tenant signing a percentage lease should ask for a lower base rent and a higher breakpoint. This will help them to pay less for rent and owe a smaller portion of their profits to the landlord.
Percentage leases are common in malls and shopping centers, so they generally adhere to industry standards. This gives landlords a little less leverage when it comes to negotiating terms. However, a landlord can still design a percentage lease agreement to favor themselves. To ensure maximum profit, a landlord should charge a higher base rent and a lower break-even point.
What Are Other Leasing Options for Commercial Tenants?
A percentage lease is one of many options for retail tenants looking to set up shop. Other popular examples of commercial leases include:
- Net leases
- Gross leases
- Modified leases
- Operating leases
- Ground leases
Frequently Asked Questions
Here are some frequently asked questions real estate students have about percentage leases in real estate:
What Is a Percentage Lease vs. a Net Lease?
A percentage lease and a net lease have key differences in terms of what the tenant pays. There are three primary types of net leases in real estate:
1. Single net lease
2. Double net lease
3. Triple net lease
Each net lease structure requires the tenant to pay base rent plus a portion of operating costs. A tenant who signs a single net lease will have fewer financial responsibilities than a tenant who signs a triple net lease.
This is different from a percentage lease, where the tenant pays base rent plus a portion of their profits. In a net lease, tenants get to keep all their profits but are responsible for costs like insurance, taxes, and maintenance.
What Is a Percentage Lease vs. a Gross Lease?
In a gross lease, the tenant pays one flat fee for rent. Unlike a percentage or net lease, the tenant does not have to worry about sharing their profits or paying operating costs. However, a gross lease often charges tenants more for rent to compensate for the other expenses.
Who Benefits the Most From a Percentage Lease?
Percentage leases benefit landlords the most, as they can choose which companies will rent their space. They can work with businesses that are more likely to succeed and, in turn, benefit financially from the business’s success.
What to Know Before the Real Estate Exam
A percentage lease is an agreement where the tenant pays base rent plus a percentage of sales to the property owner.
This key term is crucial for real estate students to understand before the big test. A percentage lease is one of the most popular lease types in commercial real estate, so it plays a vital role in the retail industry.
But there’s still a lot to learn before you ace the exam and get your license! Check out other vital terms using our online Real Estate Flashcards.