Percentage Rent

Definition of Percentage Rent

Percentage Rent is a lease provision commonly found in retail commercial real estate where a tenant pays a base monthly rent plus an additional amount based on a percentage of the gross sales generated at the specific location. While the landlord receives a guaranteed minimum rent, the percentage rent component allows the property owner to participate in the success of the tenant's business.

Detailed Description and Mechanics

The calculation of percentage rent is typically tied to a specific threshold known as the breakpoint. There are two primary types of breakpoints used in commercial lease agreements:

• Natural Breakpoint: This is calculated by dividing the annual base rent by the agreed-upon percentage. For example, if the base rent is $100,000 and the percentage rent is 5%, the natural breakpoint is $2,000,000. The tenant only pays the 5% on sales exceeding that $2,000,000 mark.
• Artificial Breakpoint: This is a flat dollar amount negotiated between the landlord and tenant, regardless of the base rent amount.

Impact on Commercial Mortgages and Underwriting

From the perspective of a commercial mortgage lender, percentage rent introduces a variable element to the property’s Net Operating Income (NOI). Because this income fluctuates based on consumer spending and the tenant's operational performance, it is treated differently than fixed base rent during the loan application process.

Key considerations for lenders include:

• Underwriting Limitations: Most lenders are conservative and may not include percentage rent when calculating the Debt Service Coverage Ratio (DSCR). If they do include it, they often apply a "haircut," or a discount, to the historical average to account for potential volatility.
• Valuation and Cap Rates: Appraisers may assign a higher risk profile to income derived from percentage rent. This can result in a higher capitalization rate for that specific portion of the income stream, potentially lowering the overall appraised value of the property for loan-to-value (LTV) purposes.
• Reporting Requirements: For a mortgage to remain in good standing, lenders often require the borrower to provide regular sales reports from tenants. This allows the lender to monitor the health of the retail center and predict future cash flows.
• Tenant Quality: Lenders look more favorably on percentage rent if the tenant is a "credit tenant" (a large, financially stable national brand) with a long history of exceeding their breakpoints.

Risk and Reward for Borrowers

For a borrower seeking a commercial mortgage, percentage rent can be a "double-edged sword." On one hand, it provides inflation protection; as prices rise, gross sales typically rise, increasing the rent collected without requiring a lease renewal. On the other hand, during economic downturns, percentage rent can evaporate quickly, leaving the borrower with only the base rent to cover their mortgage obligations. Lenders prefer a high ratio of Base Rent to Percentage Rent to ensure the property can always service its debt.