The Effect of Online Shopping on Retail Leases and Percentage Rent

“Percentage Rent” is a familiar concept to retailers and landlords and has long formed a significant aspect of the business arrangement between commercial landlords and their retail tenants.  In a lease arrangement that includes percentage rent, a landlord may negotiate a relatively reduced base rent for the chance to have some “skin in the game” by agreeing to participate in a percentage of tenant’s revenue, through gross sales, when that revenue exceeds a certain threshold amount.  Tenants appreciate this arrangement because they pay percentage rent if they are doing well and their sales exceed that negotiated threshold level. Landlords appreciate this model because it compensates them for the costs they incur in creating and maintaining successful shopping centers with amenities, such as food courts and open spaces.  If a successful shopping center drives foot traffic to individual tenants that increases their sales, tenants are often willing to compensate landlords for their part in driving that foot traffic.  The concept really is a “rising tide lifts all boats” model, in which landlords and tenants work as partners.

The explosion of on-line shopping throws a wrench into this scheme.  With more people purchasing from retailers on-line, and more retailers encouraging customers to place orders on-line, how will retail leases with percentage rent provisions be affected? Many percentage rent leases are carefully crafted to limit the types of sales that count toward the revenue in which landlord shares, often by including only those sales “made from the store.”  The question to consider: if a large percentage of a store’s sales are made on-line, can or should those sales be treated as made from, or initiated in that store, such that the landlord will be entitled to a percentage of such sales?

It is clear that out of stock items unavailable during a customer’s visit to a store, but ordered at the store and delivered directly to the customer’s home should be counted toward gross sales at that store and counted toward the percentage rent calculation.  Similarly, on-line sales made at a computer terminal in the store, or on-line sales made at the customer’s home and picked up at the store should also be counted.  It becomes much less clear when a customer never sets foot in the store itself in either placing an order or receiving goods.  It may be difficult for a landlord to assert their right to a percentage of an on-line sale made by a customer in their home where the merchandise is then delivered directly to that customer’s home where the transaction occurs without any contact with the store premises.

As traditional retail stores work to accurately account for on-line sales with their landlords, another issue has recently emerged.  Traditional on-line only merchants such as Amazon have seen a potential benefit of having a brick and mortar presence to market their business and may soon open physical locations.  The question of percentage rent may become even more difficult to account for when the store front is really merely a marketing device to drive customers to company websites.

A thoughtful balance should be found to properly compensate landlords for the sales they are driving to retailers. At the same time, from a tenant’s perspective retail leases must be carefully drafted to exclude sales that are not derived from a particular store.  If this balance is struck properly, landlord/tenant partnerships will be well positioned for success in the retail and commercial real estate markets.