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So there were some questions going around REtwit on Percentage Rent terminology, use, etc. from some folks I learn a ton from ( @sweatystartup @J264B @jmf_5 @ccchaircut @avespoli and others)
This is my niche so felt obligated to shine some light on it.
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This is my niche so felt obligated to shine some light on it.
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Why does (or doesn’t for some assets) % rent exist? It’s been around forever in some capacity but in its current form it began with malls in the 50s and 60s.
Prior to malls, downtowns and high streets were the dominant domains of commerce in the US.
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Prior to malls, downtowns and high streets were the dominant domains of commerce in the US.
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Because of the disjointed ownership of these types of retail, Landlords who were often one-off owners cared about two things- 1) maximize rent 2) acceptable credit. This approach commoditized the product and left us with “market rent”
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But the mall developers of the 50s and beyond were visionaries (Simon, Taubman) who believed in the concept of critical mass.
If they could curate a select group of uses between the anchors that satisfied a wide customer demographic then they could draw from wide trade areas.
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If they could curate a select group of uses between the anchors that satisfied a wide customer demographic then they could draw from wide trade areas.
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Wide trade areas=more traffic=more sales=higher rents. Great idea (and it worked), but there was one issue.
In order to curate the uses people wanted, you could not get businesses to pay a “market rent”. Business models vary widely, so must occupancy cost.
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In order to curate the uses people wanted, you could not get businesses to pay a “market rent”. Business models vary widely, so must occupancy cost.
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Making a deal is really very simple. It has two components. 1) Projected sales, and 2) manageable Cost of Occupancy (Base+NNN)
Reasonable occupancy is easy enough to determine, especially if you obtain financials (which you should do to determine credit).
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Reasonable occupancy is easy enough to determine, especially if you obtain financials (which you should do to determine credit).
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But what about sales projections? This is a balancing act. Tenant needs to make a sales projection in line with similar uses (don’t want someone dragging down your sales psf) and enough to pay the base rent, but not high enough where the base becomes cumbersome if you miss.
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This led to Ts underestimating (sometimes grossly) projected sales, and LLs understood this. To keep them honest they created % rent clauses to capture upside in the event T outperformed the originally negotiated deal.
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Ok, so what is a natural vs “artificial” breakpoint?
Say you project $1M and negotiate a 20% COO. Me, the LL, would propose a BP of $1.2M with a 10% pay above. $1-1.2M is cream for the T, and after that % pay is 10%, so the 20% COO continues to drop even though T pays more.
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Say you project $1M and negotiate a 20% COO. Me, the LL, would propose a BP of $1.2M with a 10% pay above. $1-1.2M is cream for the T, and after that % pay is 10%, so the 20% COO continues to drop even though T pays more.
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Well certain Tenants have more leverage (drive traffic, cotenancy, etc) and built very sophisticated RE departments (Gap in the 80/90s comes to mind). And they wanted more “cream”.
Enter the “natural breakpoint”. Divide the base rent by the percent pay and BOOM natural BP.
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Enter the “natural breakpoint”. Divide the base rent by the percent pay and BOOM natural BP.
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With heavy base rents the BP is substantially higher. This is especially true for smaller tenants where NNN make up a small % of their COO.
LLs were getting very healthy base rents from these Tenants (and remember, these Ts had leverage) so they acquiesced.
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LLs were getting very healthy base rents from these Tenants (and remember, these Ts had leverage) so they acquiesced.
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But this knife has two edges. Fast forward to modern day and sales haven’t kept pace with tax and CAM increases. So NNNs have grown, but COO often has not (or shrunk).
That means Base Rent must adjust downward to maintain the COO % (COO/Gross Rev less exclusions).
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That means Base Rent must adjust downward to maintain the COO % (COO/Gross Rev less exclusions).
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That means that under the “natural BP” formula the BPs plummet. Now tenants have great memories. “Remember that old artificial breakpoint thingy?!”
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So, that’s the background. But why are BPs so important NOW?
There is a stalemate right now in retail. LLs have years of historical sales data, but it’s pretty useless negotiating renewals. Ts are negotiating from a worst-case-scenario mindset.
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There is a stalemate right now in retail. LLs have years of historical sales data, but it’s pretty useless negotiating renewals. Ts are negotiating from a worst-case-scenario mindset.
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Do we use 80% of 2019 sales to determine COO? 70%? That’s the battle.
Returning to the stage: the artificial breakpoint.
Reducing sales projections gives you a logical number to set the artificial break. This takes downside risk from Ts, and allows LL to capture upside.
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Returning to the stage: the artificial breakpoint.
Reducing sales projections gives you a logical number to set the artificial break. This takes downside risk from Ts, and allows LL to capture upside.
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There is no other way in the current environment to allocate risk effectively and, like attorneys, that’s what retail negotiations boil down to; allocating risk.
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I’ll finish up with this. % rent requires sales reporting and has been primarily used by enclosed, open air, and power center developers. Some high street landlords can demand it, but their product is still very commoditized.
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People who habitually underutilize it are strip and unsophisticated power center investors. If you own this product, you need to change sales reporting requirements ASAP.
The middle of a pandemic is no time to gather ammo for a workout negotiation.
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The middle of a pandemic is no time to gather ammo for a workout negotiation.
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