Many people new to the restaurant business are unfamiliar with the concept of percentage rent. In a restaurant lease, percentage rent provisions allow the Landlord to share in the profits of the business, often in exchange for a lower base rent. The idea is that if the restaurant makes a lot of money, the Tenant pays more in rent. Here’s how it works.
The Breakpoint
In most cases, the restaurant tenant only pays the landlord a percentage of its sales above what is called the “breakpoint.” The breakpoint can be “unnatural” or “natural”. An unnatural breakpoint is where the number is one that the parties simply agree to (like $1.5 million in annual sales). A natural breakpoint is one that is calculated based on the amount of base rent and percentage rent factor (the percentage of gross sales above the breakpoint payable to the landlord). For example, if a tenant is paying $100,000 in annual base rent, and the percentage rent factor is 5%, the breakpoint is $2 million ($100,000 divided by .05).
The tenant will usually report its gross sales to the Landlord on a monthly (or sometimes quarterly) basis and, upon reaching the breakpoint, will start paying the landlord the agreed to percentage of gross sales. The tenant will pay that percentage rent each month for the remainder of that lease year, after which the calendar will reset, and the tenant will resume paying only base rent until the breakpoint is hit in the following year.
Gross Sales
Because the tenant is paying the Landlord a percentage of its gross sales, and doesn’t pay percentage rent at all until a threshold of gross sales is hit, how that term is defined in the restaurant’s lease is critically important. Specifically, the lease nearly always allows the tenant to exclude certain things from their calculation of gross sales, like sales taxes, amounts received for the sale of equipment, and things like that. Obviously, the more items you can get excluded, the better, but this is a frequently overlooked provision in restaurant leases. When we negotiated a gross sales definition for our restaurant clients, we regularly get items excluded from gross sales that save our clients thousands of dollars a year.
Radius Restrictions
Landlords that are sharing in the profits of a restaurant tenant are more concerned about potential competition for that restaurant, particularly competition from the same concept. For that reason, leases with percentage rent provisions nearly always also have a restriction against the tenant opening a similar restaurant within some radius. This restriction often does not come up in initial negations of a letter of intent, but will first appear in the lease itself. When negotiating a lease deal with a percentage rent component, it is important to ask if the landlord will be requesting a radius restriction to go along with it.
Audit Rights
A final thing to keep in mind about percentage rent is that the landlord will nearly always have audit rights over tenant’s books and records as related to its gross sales. These rights are important to the landlord so it can ensure that the tenant is accurately reporting its sales. Restaurant tenants with percentage rent provisions in their leases, therefore, should make sure they keep complete and accurate records. Failing to do so is often grounds for a default on their lease.
Because percentage rent is a unique provision in retail and restaurant leases, restaurant tenants who have not paid percentage rent before should consult with an experienced restaurant leasing attorney to make sure these provisions are closely reviewed and negotiated. Doing so can save the restaurant thousands in annual rent, and avoid other costly mistakes.