Percentage Lease

How a Percentage Lease Works

The mechanics of a percentage lease center around a "breakpoint," which determines when the additional rent becomes due. The components typically include:

• Base Rent (Minimum Rent): The guaranteed monthly amount the tenant pays regardless of sales volume. This provides the landlord with a baseline income to cover debt service and operating expenses.
• Percentage Rent (Overage): The additional rent paid once the tenant's sales exceed a specific threshold. This is usually calculated as a percentage of gross sales (e.g., 5% or 7%).
• The Breakpoint: The sales level at which percentage rent begins. This can be a natural breakpoint (calculated by dividing the annual base rent by the agreed-upon percentage) or an artificial breakpoint (a flat dollar amount negotiated between the parties).

The Role of Percentage Leases in Commercial Mortgages

In the context of commercial mortgages, percentage leases play a significant role in how a lender evaluates a property’s value and its ability to service debt. Because the income from a percentage lease can fluctuate, it introduces a unique set of variables for underwriters:

1. Underwriting and Income Stability: Lenders generally view percentage rent as variable income. When calculating the Debt Service Coverage Ratio (DSCR), many lenders will only consider the base rent as stable income. The "overage" or percentage portion is often discounted or excluded from the primary cash flow analysis unless the tenant has a long, consistent history of exceeding their breakpoint.

2. Valuation and Cap Rates: The potential for percentage rent can increase the overall Net Operating Income (NOI) of a property, leading to a higher valuation. However, because this income is riskier than a fixed lease, a lender might apply a slightly higher capitalization rate to the percentage rent portion to account for the volatility.

3. Risk Sharing: From a mortgage perspective, a percentage lease aligns the interests of the landlord (the borrower) and the tenant. If the tenant’s sales are high, the landlord’s increased income makes it easier to meet mortgage obligations. Conversely, during a market downturn, the drop in percentage rent could tighten the borrower's margins.

Common Use Cases

Percentage leases are most frequently found in the following commercial environments:

• Shopping Malls and Retail Centers: Where high foot traffic is a primary driver of value.
• Restaurants: Where margins are thin but sales volume can be high.
• Multi-tenant Retail Developments: Where the landlord provides significant marketing and infrastructure to drive consumer traffic to the location.

For a borrower seeking a commercial mortgage on a retail property, having credit tenants (such as national brands) on percentage leases can be a double-edged sword. While the creditworthiness of the tenant provides security, the variable nature of the rent requires the borrower to maintain higher cash reserves to satisfy the lender's risk requirements.