Franchisee Real Estate Lease: PERCENTAGE LEASE

A percentage lease is a commercial real estate lease where a franchisee (tenant) pays a base rent plus a percentage of their gross sales.

Contact Neufeld Legal PC for franchising legal matters at 403-400-4092 / 905-616-8864 or Chris@NeufeldLegal.com

The complexity of the lease agreement for the commercial real estate that is used in the franchise operation can very easily equal, or even surpass, that of the franchise disclosure document and the franchise agreement, such that retaining the legal services of an experienced lawyer to decipher, explain and negotiate the commercial lease agreement and its schedules. And for over 25 years, we have been working with business owners, including franchisees, to understand and deal with commercial lease agreements that have been presented by landlords and are foundational to their business operations. To gain the most from our legal analysis and advice as to the commercial leasing arrangement, a franchisee would be well served to understand some of the most significant commercial leasing terminology, which we have undertaken to provide you with in-depth analysis.

A percentage lease is a commercial real estate lease where a franchisee (tenant) pays a base rent plus a percentage of their gross sales. This type of lease is most commonly used in the retail sector, particularly in shopping centers, malls, and other multi-tenant retail properties.

A percentage lease has two main components that define the tenant's rental payment:

• Base Rent: This is a fixed, minimum amount of rent that the tenant must pay each month, regardless of their sales performance. The base rent in a percentage lease is typically lower than the rent in a standard, fixed-rate lease.

• Percentage Rent: This is an additional rental charge based on a percentage of the tenant's gross sales. This portion of the rent only kicks in after the tenant's sales have exceeded a specific amount, known as the breakpoint.

The breakpoint is a critical element of a percentage lease. It is the sales threshold that a tenant must reach before they begin paying percentage rent. There are two common ways to determine the breakpoint:

• Natural Breakpoint: This is calculated by dividing the annual base rent by the agreed-upon percentage rate. For example, if the annual base rent is $100,000 and the percentage rate is 5%, the natural breakpoint would be $2,000,000 ($100,000 / 0.05). The tenant would pay 5% of all gross sales that exceed this $2,000,000 threshold.

• Artificial Breakpoint: This is a negotiated number that is not tied to the base rent or percentage rate. It can be set at a higher or lower amount based on the negotiation between the landlord and tenant, often influenced by the tenant's projected sales and the property's potential.

From the tenant's perspective of assessing the advantages and disadvantages of a percentage lease:

• Advantages - Lower Fixed Costs: The lower base rent provides a financial cushion, especially during slow periods or for new businesses that need time to build their customer base.

• Advantage - Shared Risk: The rent is directly tied to the business's performance. The tenant only pays more when their business is performing well, which reduces the financial pressure during downturns.

• Disadvantage - Giving Up a Share of Success: When the business is doing exceptionally well, the tenant must give a portion of their profits to the landlord, which can feel like lost revenue.

• Disadvantage - Reporting Requirements: The tenant must accurately report their gross sales to the landlord, which can be an additional administrative task and may require the landlord to have auditing rights.

Naturally, how the concept operates in the specific context of the particular lease agreement requires experienced legal analysis, such that you make the most out of your understanding of the commercial lease agreement for your franchise. For such legal analysis and advice for your franchise and its commercial leasing arrangements, we welcome you to contact franchisee lawyer Christopher Neufeld at 403-400-4092 [Alberta], 905-616-8864 [Ontario] or Chris@NeufeldLegal.com to schedule a confidential consultation.

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Contact us via email at chris@neufeldlegal.com or call 403-400-4092 / 905-616-8864.