PERCENTAGE LEASES & RESTAURANTS: ARE THEY A GOOD FIT?
A percentage lease is a type of lease where the tenant pays a base rent plus a percentage of gross sales over what’s called a natural breakpoint. It is a common lease in large retail centers and it can be used by restaurant operators seeking locations which have historically high rents (in other words, premises in great locations).
For example let’s say monthly rent is $5,000 and you’ve negotiated a 6% lease. So $5,000 divided by .06 or 6% is as follows:
|Gross sales||Difference||6% of the Difference|
$100,000 – $83,000 = $16,000 * .06 for $1,000
Roughly $83,000 is the Natural Breakpoint. If you, as the tenant, have more than $83,000 in monthly gross sales, you’ll pay an additional 6% of the difference in rent.
This means that the tenant would then pay landlord six percent (6%) of any Gross Sales over $1,250,000. If the tenant’s monthly Gross Sales are $100,000, then the tenant would pay landlord 6% of the difference between gross sales over the natural breakpoint. See table and equation above. Rent for the tenant would be $5,000 + $1,000, or $6,000.
Now let’s discuss NNNs or CAM. More often than not, the restaurant operator with a percentage lease also pays NNNs or CAM fees. These are expenses the landlord incurs as an owner of the property and passes them on to tenants on a prorated basis. You can read more about these fees in earlier blog posts. If the lease also includes NNN or CAM fees, it is VERY important that the restaurant operator take those fees into account when negotiating the percentage amount that will be used in the lease. This is the difference between rent and occupancy costs. Rent generally refers to the base rent a tenant pays, so in my example above base rent would be $5,000. Whereas occupancy costs takes into account base rent and the prorated expenses of the landlord that are passed on to the tenant as NNN or CAM fees. These are usually expressed in an amount per square foot. So $0.50 per square foot or $1.25 per square foot. Let say that in addition to the $5,000 monthly rent, the restaurant operator is also paying and additional $1,000 month in NNN fees. So rent is $5,000 and occupancy costs are $1,000.
In an industry with a lot of history, like the restaurant industry, the margins for success are well established. Due to Covid and the change in consumer dining habits, these margins may be readjusting, but for our purposes today, occupancy costs should be around 7-9% for a restaurateur to achieve profitability. This margin can change depending on various factors and the restaurant operator should talk to a qualified restaurant broker or consultant to find out the occupancy costs margin that should be used.
If the restaurant monthly gross sales were $100K base rent calculated at 6% with the roughly $83K breakpoint would be $6,000 + the $1,000 NNN fee, occupancy costs would be $7,000.
With gross sales at $100K, occupancy costs as a percentage of gross sales is 7%. For most locations this margin should be fine. However, it is VERY important that the restaurant operator projects future occupancy costs when negotiating the right rate for the percentage lease. If the rate is too high when the NNNs and CAMs are added then the operator is going to have trouble achieving and maintaining profitability.
Many first-time operators don’t like the thought of a percentage lease. The landlord is privy to the restaurant financials or at least gross sales, but oftentimes it can be a good compromise for landlords who have an inflated sense of what rent the operator can support.
Items up for negotiation with percentage leases:
- The breakpoint. I used a natural breakpoint here, but a higher breakpoint can mean less rent expense.
- The frequency or reconciliation: will the landlord adjust the rent monthly, quarterly, or annually?
- What sales are included or excluded from the gross sales? For instance, will the sales for off-site catering be included?
There are several other important terms to consider when negotiating a percentage lease and I highly recommend tenants work with a knowledgeable lease attorney at the earliest stage of lease development. This is usually the letter of interest. Once the lease is in place, tenants are good to go, so paying for an attorney to help secure the best possible lease terms is money very well spent.
Ryn Longmaid is a restaurant broker and consultant at Santa Rosa Business & Commercial in the San Francisco North Bay and the host and founder of the Facebook Live Series, Deep Dish: discussions on the business of restaurants for restaurateurs, restaurant buyers and sellers and the restaurant curious.
As well as being a licensed real estate broker, Ryn is a CBB with the California Association of Business Brokers (CABB), a CBI with the IBBA and she holds an MBA in Sustainable Business Management. In addition to being a proficient business broker, Ryn has over 20 years’ experience in the restaurant, hospitality, and food industries. She has served as the executive chef for Amy’s Kitchen, personal chef to actor Don Johnson, and she founded and operated a successful and longstanding restaurant. She has also held teaching posts in restaurant management at the Art Institute-San Francisco and The Culinary Institute of America-Greystone.