Before I started working with restaurants as an attorney, I did not know anything about the concept of percentage rent. I didn’t even know it existed. If you are reading this, you probably understand the basic idea of percentage rent, but if not: it is where a tenant pays a percentage of its annual revenues (over a certain threshold) to the landlord as additional rent. The threshold is known as the “breakpoint” and the percentage that is paid (usually 5-6%) is the “percentage rent factor.” Once your sales hit that breakpoint, you start paying the additional percentage rent. We wrote about the basic concept of percentage rent here, if you’d like to learn more. But we wanted to do a little deeper dive here, because we find that many of our newer clients are paying more than they should.
When we advise our clients on the percentage rent provisions in a restaurant lease, we suggest they think of percentage rent like taxes. The comparison is apt in two important ways. First, restaurant owners need to plan for it. If you are doing well in a given year, you need to have an idea when your sales will surpass the breakpoint for that year, such that you have to start paying percentage rent. If you are doing particularly well, you may have to pay percentage rent for 2, 3, or 4 months. That means your rent will go up significantly for those months. For example, if your breakpoint is $2 million, and you are on track to do $3 million in sales, you will have to pay percentage rent on that additional million dollars. Even at a percentage rent factor of 5 percent, that would be an additional $50,000 in rent over the course of those few months.
In terms of lease negotiation, however, there is another very important way that paying percentage rent is like paying taxes: finding deductions. We all are familiar with the idea that if we can find additional tax deductions, we can reduce the amount we owe in taxes. The same idea exists in percentage rent. Every restaurant lease that has percentage rent as a component, also contains a section listing items a restaurant tenant can deduct from its gross sales for percentage rent purposes. Common ones include sales and excise taxes paid to the government, and sales of assets that are made outside of the ordinary course of business (e.g. selling used equipment to another restaurant owner).
But this is where so many restaurant tenants leave dollars on the table – lots of dollars. Just like a good accountant can save you money by telling you what deductions are available to you under the tax code, a good restaurant leasing lawyer can identify additional items that should be excluded from your gross sales for purposes of calculating your percentage rent – and make sure those exclusions are included in the lease. It is not uncommon (in fact, it is quite common indeed) for landlords that we work with to permit our restaurant clients to exclude categories of revenue amounting to tens or even hundreds of thousands of dollars each year, leading to many thousands of dollars in savings. And it never ceases to amaze me when, in the course of working with a new client who has several existing stores (and leases), they tell me that their prior attorneys never suggested these deductions.
So if you are negotiating a new lease, and the lease requires the payment of percentage rent, make sure you ask your attorney about additional allowable deductions from gross sales. And if your attorney does not know what to ask for, consider getting someone else to take a look at it.