Has COVID changed the rental percentage for good?

The catastrophic economic impacts of recurring COVID-19 closures have left retail stores in dire straits, which in turn has put their owners in a bind. As office landlords offered rent concessions and postponed lease start dates for their tenants, retail landlords tried to find ways to adapt their tenancy structure to reflect market conditions as well. A popular solution was to adjust the length of a tenant’s lease from fixed rent to revenue-based rent, at least until markets recover from the COVID crisis.

A turnover rent, also known as a percentage lease, is about as simple as it sounds. The tenant agrees to pay a base rent, operating costs and a monthly variable cost based on the monthly income generated by the tenant’s activity. The practice is more widely accepted in Europe, but in the United States accepting too many of these leases could have been bad news for commercial landlords. But now that so many businesses have negotiated a percentage lease in order to survive the lack of sales due to pandemic shutdowns, percentage leases may be the post-pandemic norm.

The rent of the world as we know it

Percentage leases are unique to each company, but they generally follow the same structure. A merchant rents storage space. The store signs a lease for the space with a base rent of a few dollars per square foot, plus a 1% rent based on a sales break point. This breakpoint is calculated by the annual rent (the square footage multiplied by the dollar amount per square foot) divided by the rent percentage of 1%.

Let’s say a retailer has a 50,000 square foot store that has a base rent of $5 per square foot. The base rent would be $250,000 and that retailer’s break point would be $25,000,000. If the retailer’s sales volume exceeds $25,000,000, the retailer will pay 1% of the excess sales. So, in the case where a retailer earns $30,000,000 per year, the percentage rent would be $50,000 plus base rent, or $300,000 in total. However, if for some reason sales drop the following year, the tenant will only have to pay $250,000 for that year.

Before COVID, most mall or shopping center tenants were on a fixed rate lease. “The minority of tenants would have percentage leases,” said Lisa Wagner, director of the Outlet Research Group, because fixed-rate leases are strong and consistent. In a percentage lease, rental income can fluctuate when a retailer has a bumpy financial month. “It was generally scary for the owners to accept many [percentage leases] because investors would have found the risk intolerable,” Wagner added. Because of the risk associated with variability, Wagner told me that percentage letting was previously limited to retailers who had the largest and smallest real estate footprints in a mall: department store anchor tenants and tenants smaller transients with higher margins. such as mall carts and kiosks.

The irony behind the risk aversion for these types of leases, according to Wagner, is that when tenants under percentage leases do well, they are usually the best performers in a landlord’s portfolio. Yes, a month of low sales would equate to a lower rent payment, but when a tenant experiences a higher rate of sales, rents go up in tandem.

Percentage leases are not without their own problems. Tracking sales to arbitrate rent each month can be a difficult task. Unless tenants seek rent relief from their landlord, they are generally reluctant to disclose their sales data. In a fixed-term lease, landlords are passive actors in a tenant’s business. A percentage lease transforms this relationship, blurring the line between owner and partner. Additionally, landlords and their lenders need to do more due diligence on their tenants’ businesses and ensure that the business continues to meet expectations over the life of the loan.

Almost all percentage leases are unique and require a collaborative effort between tenant and landlord, as percentage leases force landlords to consider parameters that they are not quite familiar with. Daily retail events such as returns, employee discounts, and gift certificates are variables that can easily skew rental percentage measurements. What defines “turnover” is the most critical element a lender must understand in a lease. Lenders may consider imposing additional financial covenants, in addition to the standard loan-to-value and yield-on-debt covenants, which take into account both the borrower’s and the tenant’s financial situation.

Lock logic

Before the pandemic, long-term commercial leases were considered low risk. For landlords, they have provided stable and consistent rental income regardless of the tenant’s sales volume. Of course, fixed rents don’t entirely eliminate tenants’ business risk, but in light of the pandemic that has thrown the global economy into a series of stumbles, fixed rents have gone from a low-risk deal to the landlord has high stakes, as most retailers lost revenue and couldn’t pay their rent. Landlords have had to deal with the growing reality of bleeding out an empty property since closures decimated the retail sector. The prospects of tenants able to replace an outgoing tenant have dwindled, so retaining a struggling tenant was often in the landlord’s best interest. The pandemic was so fraught with uncertainty that allowing more retailers than usual an option to operate on a percentage lease seemed like a temporary fix that wouldn’t be necessary in the long run. But the virus didn’t magically disappear in a matter of months, much to everyone’s dismay.

Landlords offering retailers a percentage lease in their mall was initially a temporary band-aid to keep space occupied, but the move ultimately demonstrated to businesses that a flexible arrangement was more desirable than a long-term fixed lease. David Abramson, founder and managing director of Cedar Dean Group, a London-based commercial property consultancy, said The New York Times last year that the relationship between landlords and tenants “has definitely become more strained because of the pandemic”, but that landlords were undergoing “a complete change in attitude” by adopting percentage leases.

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Forty percent of retail landlords surveyed by Colliers in May 2020 said they would be more likely to factor a tenant’s sales into their lease agreements, which seems surprising given the complexity of the realization of a lease in percentage. Again, the onset of the pandemic was fraught with uncertainty and unprecedented decision-making, but continued demand for percentage leases may persist thanks to the current state of the market.

But renters are also emerging from the pandemic with a new awareness of the paradigm shift in percentage renting, just in time for interest rates to rise. The Federal Reserve is increasingly aggressive with raising interest rates to fight inflation, and interest rates are a key driver of commercial rent prices. Lisa Wagner of The Outlet Research Group believes that the subsequent increase in commercial rents will have a direct impact on the demand for percentage leases. “I think this will continue to encourage more tenants to apply for percentage leases instead of a fixed lease,” she said.

However, many retailers may regret their eagerness to renew their percentage lease in an inflationary environment. Retail is finally alive, with sales expected to climb between 6% and 8% in 2022, according to the National Retail Federation. Higher consumer prices mean retailers renting on a percentage lease could more easily exceed their percentage break point and have to part with more of their revenue than expected. This year’s forecast shows a slower growth rate for retailers than in 2021, but it’s still higher than the pre-pandemic rate. This means landlords who obligated a percentage lease are finally reaping the high rewards they’ve been crossing their fingers for in 2020.

In a volatile market economy with a lingering pandemic in the background, there may not be a truly win-win leasing solution between a landlord and a commercial tenant. Yet the COVID-19 virus has demonstrated that fixed-rate leases do not avoid financial risk, as investors and landlords once assumed. But as landlords have slowly come to terms with allowing more of their tenants to sign percentage leases, their reluctance to have too much in their wallets could very well return. As consumer prices continue to rise, landlords can expect more tenants to try to negotiate higher rates for their breakpoints. So while percentage leasing is more collaborative than the traditional leasing model, negotiations on either side are unlikely to get any easier anytime soon. .

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