Percentage rent -- Not as scary as it seems 🎃

Percentage rent has a PR problem. It’s right up there with the personal guaranty on the list of concepts retailers love to hate... but should it be? The initial feeling of “oh haaaale no” is tough to overcome, but just like colonoscopies and unmedicated childbirth, once you learn how it really works, it’s not as bad as it sounds…in fact, a lot of people do it willingly.

💡 ICYMI there are two types of percentage rent. One is where the rent payment is a set percentage of revenues each month instead of a fixed base rent. Tenants love this, and they should. We’re talking about the other percentage rent – where above a certain threshold, a tenant pays some additional rent on top of their regular rent.

🎃  It turns out that Halloween is the perfect time to explain percentage rent in an approachable and fun-sized way. Enjoy.

It’s Halloween and for the past few weeks, Mom and Dad have spent time and money buying Alice’s Halloween costume, stockpiling candy, and decorating the house. As a result, Alice gets to fully participate and enjoy Halloween with everything she asked for and more.

Mom and Dad expect 10 pieces of candy in exchange for their investment in Alice’s good time and because they pay for the house in a lovely neighborhood known for its top-notch trick or treating.

According to expert children everywhere, the industry standard definition of a “successful” Halloween is that the “parents’ take” should be no more than 10% of a kid’s total haul.

So to be “successful,” Alice needs to bring in at least 100 pieces of candy, which feels fine to her. She’s confident she can do it, and after she pays Mom and Dad, she’ll still have at least 3 pieces of candy for each day of November.

Now, let’s say Mom and Dad really wanted to get 15 pieces of candy. While they’re confident that Alice will haul at least 150 pieces, Alice is not. So as understanding parents, they agree to just 10 pieces to make sure Alice is comfortable with her commitment based on her own candy haul projections, but as a compromise, they add “percentage parents’ take” at a 6% natural breakpoint.

This means if Alice hauls so much candy that her 10 piece “parent take” is 6% or less of her total haul, Alice would pay an additional 6% of the overage. So Alice's natural breakpoint would be 167 pieces. Only if she hauls more than 167 pieces does she owe more candy to her parents. Here’s how the math works:

10 ➗ 0.06 = 167

So if Alice hauls 80 pieces of candy, she owes 10 pieces, keeps 70 pieces

      🍬 120 pieces…she owes 10 pieces, keeps 110 pieces

      🍬 150 pieces…she owes 10 pieces, keeps 140 pieces

      🍬 200 pieces…she owes 10 + 2 extra pieces, keeps 188 pieces

      🍬 300 pieces because it's an epic night, she owes 8 extra pieces. She owes 18 and keeps 282 pieces.

🦷 This is a topic for another day, but Mom and Dad could also add a candy clawback clause, wherein Alice may only keep her candy so long as she maintains her toothbrushing schedule.

Yes, if she crushes Halloween, Mom and Dad get more candy. But is Alice mad? HECK TO THE NO!* She’s still got way more candy than the industry standard for a successful Halloween. She’s thrilled that now she can use the extra candy to bribe kids on the bus or save for a cold and rainy day in January. 

💰 Percentage rent is only owed WHEN YOU’RE CRUSHING IT. 💰

Base rents are negotiated to reflect what both the landlord and the tenant agree is reasonable for that space on that block in this area. When you’re doing a lot more business than your base rent requires, one could reasonably argue that the base rent was not set high enough initially.

The calculation in real estate is exactly like the candy example:

      Rent ➗ Percentage = Breakpoint

      $100,000 in annual rent at a 6% natural breakpoint = $1,666,667

So if your sales are $1,800,000, that’s $133,333 more than the breakpoint, you’d owe $8,000 to the landlord and take $125,333 to the bank.

Landlords ask for percentage rent when they really think you can afford a higher base rent, but to make a deal, they’ll agree to a lower number. They’ll be able to capture a little more value if and only if you exceed your own expectations. Win-win.

So long as you’re comfortable with the breakpoint you agree to, percentage rent should never feel unfair or burdensome. Think of it like tossing some extra candy at your landlord to say “hey, thanks for buying this building and renting to me. We’re successful here together.”

*actual 5th grade lingo