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Determining Percentage Rent

Many shopping center leases require the tenant to pay both a fixed annual minimum rent and a percentage rent. Percentage rent is calculated as a percentage of the tenant's annual sales made in or from the premises. Defining what constitutes a "sale" for purposes of calculating percentage rent, and determining what may be excluded or deducted, often is the subject of intense negotiation between landlord and tenant.

Since landlords benefit from a broad interpretation, they will attempt to define "sales" as any and all receipts or income from the sale of goods and services sold in, at or from the premises. In addition, landlords will want to include any consideration received for any other business conducted, not only by the tenant, but all other sublessees, licensees, concessionaires, and other occupants of the premises. The defined term commonly used is "gross sales" or "net sales."

Tenants will want to make a distinction between a true "sale" of merchandise and services and other income the tenant might receive unrelated to sales. Such other income should be excluded from the definition of "sale" at the outset. Some common exclusions are:

* Sublease, concession and license fees. A tenant may be willing to include the actual sales generated by a sublessee, licensee, or concessionaire, but will want to exclude the fees paid to the tenant under the sublease, license, or concession agreement. This income is not a "sale" of merchandise or services.

* Sale of furniture or fixtures. The sale of furniture or fixtures that have been used in the premises, but are not sold in the ordinary course of the tenant's business, should not be a sale on which landlord should be able to collect percentage rent. The same argument can be made for a bulk sale of out-of-date merchandise that is not sold at retail in the ordinary course of business.

* Proceeds from insurance or warranties. If the tenant receives proceeds of insurance for loss or damage to its inventory or improvements to the premises, such income is not a "sale" of the tenant's merchandise in the ordinary course of business, and should not be used to determine percentage rent.

In contrast to an exclusion from gross sales, which treats the transaction as not a sale at all, a deduction is a reduction of the amount of an actual sale. The following are common deductions:

* Sales and other taxes. Federal, state and local taxes on merchandise are not income to the tenant; the tenant is merely acting as a collection agent for the taxing authority. Thus, taxes should be deducted from the sales price before percentage is calculated.

* Interest and finance charges. A tenant's carrying charges on credit sales cover the tenant's cost of money and are not income on the sale of the merchandise. That portion of the sale should be deducted. However, to the extent that finance charges are a profit center for the tenant, landlords are in their rights to insist that the profit should be included. Also, landlords often will only agree to this deduction for interest earned on the tenant's own credit program, and not fees tenant pays to third party credit card companies.

* Bad debts. An amount that was originally included in gross sales for purposes of determining percentage rent may ultimately be uncollectible -- and therefore not income to the tenant -- if the sale was made on credit. The deduction is made from future gross sales when the amount is determined to be uncollectible. Landlords often vigorously resist this deduction, arguing they should not be penalized if the tenant takes on bad credit risks. A common compromise for tenants with leverage is to limit the deduction to a certain percentage of the tenant's annual total gross sales, usually between 1 percent to 3 percent.

* Another significant concern is how to define when a sale actually occurred in or from the premises. Landlords want to include any sale that was either made or filled in the premises (for example, a catalog order placed from the premises, but filled from a catalog warehouse). Tenants must be wary of such a provision, because they could be paying percentage rent twice on the same sale: once to the landlord where the order was placed, and once to the landlord of the premises where the order was filled.

This issue takes on even more significance for landlords with the onset of Internet sales. The actual sale may not be made at the premises, but could be filled from the premises. Landlords will want to be sure such sales are not lost for purposes of calculating percentage rent.

M. Rosie Rees is a lawyer in the Chicago office of Los Angeles-based Pircher, Nichols & Meeks.

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