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HOT TOPIC: So long percentage rents?

Last year, retail industry leaders detected a potential crack in traditional lease structures that combine fixed and percentage rents. In interviews with more than 100 developers, bankers, brokers and investors, Lend Lease Real Estate Investments and PriceWaterhouseCoopers found that industry leaders are wondering if percentage rents will survive the rise of e-retail.

The results of these interviews appear in summary in a joint publication by the two companies called Emerging Trends in Real Estate 2001.

“The best days for percentage rent structures may be past,” says the report. “Currently, mall owners wrestle with stores over how to deal with returns of web-purchased merchandise. Over time, it may become easier to charge rents based strictly on square footage.”

Investors already discount percentage rents. “Investors buy a property for a dollar and hope to sell it for a dollar fifty,” says Bernie Haddigan, senior vice president and divisional manager of investment and sales with the Atlanta office of Marcus & Millichap. “Property value is a function of the current and potential income stream. A buyer who believes a property will generate rents at a certain level will pay in proportion to that. If you had two identical properties with identical tenants doing identical volumes, and one used just a stated lease rate and the other linked a stated rate to a percentage rent, investors would pay more for the secure income.”

On the other hand, agents writing leases today report no unusual changes in the leases they handle. “In the past 12 months, 95 of 100 deals I've been involved in contained some kind of percentage rent clause,” says John Gerdes, vice president and director of retail with L&B Realty Advisors, Inc., a Dallas-based brokerage firm.

Traditional percentage rent clauses

Malls represent the traditional home of percentage rent. Strip centers and power centers have never made more than occasional use of the device, primarily because the anchors those centers need won't agree to significant percentage structures and smaller in-line stores do not report sales in ways that facilitate percentage rents.

Malls, on the other hand, attract top retailers. And fortress malls attract more retailers than space allows. Demand for mall space leads to percentage rents.

If, for example, a retailer agrees to lease an in-line mall space of 1,000 sq. ft. at a stated rent of $20 per sq. ft., the landlord might also add a percentage rent to sales above $200,000 per year. “Landlords know retailers will value rent at a factor of approximately 10% or so of gross sales — the percentage may be more or less depending on the retail category,” Gerdes says.

By dividing the rent factor, in this case 10%, into an annual rent of $20,000, you come up with what is called the “natural break point” or $200,000, he explains.

“In this case, the landlord might ask for a percentage rent on gross sales over $200,000 per year. The percentage depends upon the retail category. Fast food, jewelry stores and other retailers with high mark-ups might pay percentages between 8% and 10%, while an apparel retailer with a lower mark-up might pay only 5%.

“There are variations to this formula, but this is the general approach,” Gerdes continues, “and I don't see it changing.”

The effect of e-commerce

The industry players interviewed by Lend Lease and PriceWaterhouseCoopers feel that e-commerce may alter the tradition of percentage rent. Their argument suggests that merchandise returns from consumers making e-commerce returns will begin to consistently lower gross store sales below levels where percentage rates would kick in.

According to Doug Healy, principal and head of the retail group with Lend Lease, that scenario is a theoretical extreme. “At the other extreme, mall tenants might fill Internet orders with store merchandise, and the landlord might demand that sales made to customers within ZIP codes served by the mall be included in gross sales and used to trigger percentage rent,” he says.”But the reality is business as usual.”

In fact, it could take years before e-commerce develops a market share that would significantly affect percentage rents, Healy says, pointing to U.S. Department of Commerce statistics that place e-retail sales at approximately 0.7% of total retail sales (excluding autos).

“That's not a significant market share,” Healy says. “What is significant? Ten percent? Maybe. But that's a long way in the future.”

Even when the future arrives and e-commerce earns a place in the debate, the deciding factors will likely be no different than what they are today. Landlords will ask for percentage rents. Retailers will resist. The sides will negotiate. In strong malls, landlords will win. In weak malls, retailers will win. Business as usual.

Mike Fickes is a Baltimore-based writer.

Doug Healy Principal Lend Lease “Mall tenants might fill Internet orders with store merchandise, and the landlord might demand that sales made to customers within ZIP codes served by the mall be included in gross sales and used to trigger percentage rent, but the reality is business as usual.”

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