Percentage rent
Also called Overage rent, Percentage lease.
Percentage rent is additional rent a retail tenant pays based on sales above a threshold called the breakpoint. It gives the landlord participation in a tenant's success while keeping base rent at a level the tenant can carry in a weak year.
How it works
Most percentage rent clauses use a natural breakpoint, which is base rent divided by the percentage rate. Set that way, the tenant pays nothing extra until its sales are high enough that the percentage rate alone would have produced the base rent, after which it pays the stated percentage on every incremental dollar. An artificial breakpoint is any negotiated number instead, and a lower one starts the participation sooner.
Rates vary by category and roughly track gross margin. Grocery and other high-volume, low-margin categories sit at the low end, often 1 to 2 percent. Apparel and specialty retail commonly sit at 5 to 8 percent. Restaurants vary widely. The rate and the breakpoint are negotiated together, and lowering base rent in exchange for a lower breakpoint converts fixed income into variable income.
For underwriting, percentage rent should be treated as the lowest-quality income on the rent roll. It is unsecured by any contractual minimum, it moves with consumer spending, and it can go to zero without the tenant defaulting. Buyers routinely discount it or exclude it from the income capitalised at exit, and lenders frequently give it no credit at all.
Formula
Percentage rent = (reported sales - breakpoint) x percentage rate, floored at zero- Natural breakpoint = annual base rent / percentage rate
- Sales are normally reported annually and defined in the lease, with exclusions for returns, gift cards and internet orders fulfilled elsewhere
- Most leases give the landlord an audit right over reported sales
Worked example
Illustrative. Base rent $120,000 a year, percentage rate 6 percent, natural breakpoint.
| Natural breakpoint$120,000 / 6% | $2,000,000 |
|---|---|
| Sales of $1,800,000 | $0 of percentage rent |
| Sales of $2,600,000 | $36,000 of percentage rent |
| Total rent at $2,600,000 of sales | $156,000 |
| Occupancy cost ratio at that level | 6.0% |
| Effective rate on sales above the breakpoint | 6.0% |
The occupancy cost ratio, total rent divided by sales, is the health check worth running. A ratio drifting above the norm for the category is an early warning that the tenant will struggle at renewal, whatever the percentage rent is currently contributing.
The common mistake
Capitalising percentage rent at the exit cap rate
Including variable overage rent in the NOI that gets capitalised at sale treats the most volatile income in the building as though it were as reliable as contractual base rent. A sophisticated buyer will strip it out or apply a much higher cap rate to it. Model it in the cash flow where it belongs, exclude it from or heavily discount it in the exit valuation, and watch the occupancy cost ratio rather than the percentage rent dollars, because the ratio is what predicts whether the base rent survives renewal.
Related terms
- Triple net and expense recoveriesUnder a triple net lease the tenant pays base rent plus its share of the property's taxes, insurance and common area maintenance. Expense recoveries are the mechanism that bills those costs back, normally as a pro rata share based on the tenant's proportion of the building's leasable area.
- Lease rolloverLease rollover is what happens when a lease expires: the tenant renews, or leaves and the space sits empty until a new tenant is found and fitted out. Modelling it means applying a renewal probability, downtime, leasing capital and a new market rent to every expiring lease.
- Net operating incomeNet operating income is a property's effective gross income less all operating expenses, before debt service, income taxes, depreciation and capital expenditure. It is the figure a cap rate is applied to, the numerator of debt yield and DSCR, and the number a purchase price is ultimately negotiated against.
- Going-in versus exit cap rateThe going-in cap rate is year-one NOI divided by the purchase price. The exit or terminal cap rate is the rate applied to the forward NOI at the end of the hold to estimate the sale price. The spread between them is one of the largest and least evidenced assumptions in any underwriting.
Every figure, traced to its source
Altyst computes these in exact decimal arithmetic, not with a language model, and clicking any number shows the formula behind it.