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By Stephen W. Snively
Most shopping center tenants pay percentage rent based on the volume of sales at their stores. Recently, many of those tenants have developed Web sites for the sale of merchandise. The list of traditional shopping center retailers that sell merchandise through Web sites grows steadily. Macys.com, Sears.com, Gap.com, VictoriasSecret. com, EddieBauer.com and Nordstrom.com are just a few. Visit any of them and you will discover a sophisticated marketing program designed to lure consumers and maximize sales. Merchandise is displayed attractively and often organized like a department store or according to product type, brand, theme, price range or color. Many Web sites accept credit card applications and offer special promotions, delivery options and account information. Some provide store location information.
This use of the Internet for selling merchandise diverts sales from traditional stores and threatens to kill percentage rent for shopping center owners. This article reviews the origins and calculation of percentage rent and argues that Internet sales should be included in percentage rent.
Reaction of Shopping Center Owners
The Internet as a medium for communication was unknown to most consumers a few years ago but has emerged as a technology that may dominate the retail industry. Although the dollar amount of Internet sales is still relatively small, it is growing rapidly, which scares many owners of leased retail properties.
Trade organizations for the shopping center industry and real estate investors have fought special tax treatment for e-commerce transactions. They believe that if the cost of e-commerce is greater, the shift in sales from stores to the Internet will slow. Some shopping center owners have launched counterattacks to protect their percentage rent. Last Christmas, the owner of the Galleria Mall in St. Louis, Missouri prohibited its 170 tenants from promoting Web sites in their stores. The ban applied to signs, posters, dotcom addresses on shopping bags, window stickers and other materials that promoted Internet sales. Although most tenants ignored the ban, a few threatened suit, which prompted a quick retreat by the mall owner.
Other mall owners are attracting computer users back to the malls by offering on-line coupons redeemable when a purchase is made at the retail stores, e-mailing the gift requests of mall shoppers to their friends and relatives and streamlining purchasing and delivery procedures.
Although it will take years to evaluate the effect of these long-term efforts, two questions confront landlords and tenants now. First, should courts interpret percentage rent clauses in existing leases to include Internet sales? Second, if parties agree that Internet sales should be included in new leases, how should they draft the provision? An understanding of what percentage rent is and how it originated helps to answer these questions.
Minimum Rent and Percentage Rent
Most retail tenants pay rent in a fixed amount each month, often based on the rentable square feet of the store. From the landlord's perspective, this amount is sufficient to cover its debt service and provides an acceptable return on its capital investment. From the tenant's perspective, this amount is what it can afford, based on a conservative estimate of sales revenues. Fixed rent often increases on a predetermined schedule or in accordance with the Consumer Price Index and is not dependent on the financial success of the business conducted in the leased premises. This fixed monthly payment of minimum rent is often combined with percentage rent.
Percentage rent, which is based on the gross revenues that the tenant generates at the store, is common in the retail industry. The lease establishes a formula for calculating percentage rent that considers gross sales, a threshold sales figure and a percentage rate.
Historical Origins of Percentage Rent
The concept of percentage rent originated in the Depression era, after many retailers were forced into bankruptcy by fixed monthly rent obligations. National chain stores with economic leverage and an appetite for long-term leases, such as W.T. Grant Company, began to negotiate leases that provided for no minimum rent but percentage rent equivalent to 1% of gross sales. Landlords initially used percentage rent provisions in retail leases as a mechanism to share in the success of properties with prime downtown locations. That is why percentage rent is rarely used in less desirable locations, where success is more a function of retailer expertise than store location. By the time tenants moved to shopping centers in the suburbs after World War II, percentage rent clauses were widely accepted in the retail industry.
Percentage rent can balance the economic positions of landlord and tenant. For the landlord, percentage rent is a hedge against inflation and a way to share in the long-term prosperity of a successful tenant. For the tenant, percentage rent is a way to reduce costs during rough economic times. From a historical perspective, when a tenant agrees to pay percentage rent, it acknowledges the right of the landlord to share in the increased sales resulting from the store's strategic location within a particular market.
Percentage Rent Formula
The definition of "gross sales" is central to the percentage rent formula. A well drafted retail lease favoring the landlord includes all sources of revenues relating to use of the leased premises and excludes only narrowly defined categories of transactions. There are two methods for calculating percentage rent. The traditional method takes a percentage of gross sales and deducts annual minimum rent and sometimes other expenses paid by the tenant that increase over time, such as ad valorem real estate taxes. The breakpoint method takes a percentage of gross sales in excess of a dollar amount that is often set independently from minimum annual rent.
A natural breakpoint is the volume of gross sales that a tenant must generate to pay the annual minimum rent, at a rate equal to the applicable percentage rate. It is calculated by dividing the annual minimum rent by the percentage rate. For instance, if the minimum rent is $700,000 per year and the percentage for rent rate is 7%, then the natural breakpoint would be $10 million. The underlying rationale is that the landlord is paid its percentage (7%) of gross sales equal to the breakpoint ($10 million) in the form of annual minimum rent ($700,000) and therefore should receive percentage rent only on the excess. If the percentage rate is lower, the natural breakpoint will be higher. A formula with a natural breakpoint will generate the same percentage rent as the traditional method.
The amount of percentage rent can decrease or increase independently with an artificial breakpoint. An artificial breakpoint may be higher or lower than a natural breakpoint and is not tied to annual minimum rent. The landlord might accept less minimum rent if the tenant agrees to a lower artificial breakpoint and more percentage rent. High volume tenants with economic strength might prefer higher minimum rent in exchange for lower percentage rent. With long-term leases, landlords may rely more on percentage rent to reduce the risks of inflation.
The final step in calculating percentage rent is to multiply gross sales in excess of the breakpoint, whether natural or artificial, by a percentage rate. Different percentage rates are used for different types of stores. The higher the profit margin on the merchandise, the higher the rate. For instance, the percentage rate is usually lower for a supermarket (higher volume and lower profit margin) than for a jewelry store (lower volume and higher profit margin).
Percentage rent is usually calculated and paid annually. Leases for tenants who pay percentage rent often require them to maintain contemporaneous records of sales, submit periodic sales reports, allow landlords to audit their books, sell a specific type of merchandise and establish minimum hours of operation. Those leases often include continuous operations clauses, prohibiting the tenant from "going dark." A noncompetition provision may prohibit the tenant from opening additional stores within a stated radius of the leased premises.
Noncompetition clauses prevent the dilution of sales and the corresponding reduction in percentage rent that could result from an additional store in the same market area. Leases often provide that, if the tenant violates an express covenant not to compete, sales from the new store will be included in the gross sales of the original store for percentage rent purposes.
Interpretation of Existing Leases
Courts will enforce most lease language that is clear, unambiguous and capable of only one reasonable interpretation. For instance, if the lease excludes catalog sales or mail orders from gross sales, courts will enforce that provision. Courts should also enforce provisions specifically excluding Internet sales. Most existing retail leases were signed before Internet sales were common and do not state whether Internet sales should be a part of gross sales for calculating percentage rent. When a lease does not specifically address a particular matter in dispute, courts will seek to effectuate the intent of the parties by considering the language of the lease, the parties' objectives and surrounding circumstances. A court may imply a covenant for matters that were so clearly contemplated by both landlord and tenant that neither deemed it necessary to address them in the lease. Courts will only recognize implied covenants when necessary to effectuate the intent of the parties.
Although a percentage rent clause will not be implied in a lease when it did not exist, some courts have implied covenants about what revenues constitute gross sales for percentage rent purposes. In 1948, when percentage rent was emerging in the retail industry, an editorial note from the Harvard Law Review concluded that: "To prevent complete frustration of the purpose of the percentage clause, courts should find no difficulty in implying the duty to refrain from diverting sales to a neighboring location. . . ." Note, The Percentage Lease-Its Function and Drafting Problems, 61 Harv. L. Rev. 317, 326 (1948).
Courts have held that tenants may not divert sales to reduce percentage rent. If a tenant cuts a hole in the wall of its store and moves merchandise into an adjacent building, percentage rent may be based on total sales, including those from the adjacent building. Cissna v. Baron, 270 P. 1022 (Wash. 1928). Gross sales may include goods delivered from a location other than the demised premises. Michigan v. Evans, 531 N.E.2d 872 (Ill. App. Ct. 1988). Sales from the off-premises business of a tenant may be deemed a "concession" and thereby included for percentage rent purposes. Elfstrom v. Brown, 366 P.2d 728 (Ore. 1961). Sales made by a tenant outside a store to customers who telephoned the store may be included in gross sales. Krieger v. Elkins, 620 P.2d. 370 (Nev. 1980). When tenants have opened new stores, many courts have declined to include sales from those stores in the percentage rent for the original stores if the original leases did not prohibit their operation. Downtown v. Burrows, 518 N.E.2d 564 (Ohio Ct. App. 1986). Those cases involved the opening of new stores by tenants and predated the existence of retail Web sites.
Implied Covenant of Capital Investment
The author has located no reported cases addressing Internet sales and percentage rent, but analogies may be made to cases concerning the diversion of sales. Many retail leases do not prohibit tenants from opening new stores nearby. Nonetheless, when the landlord and tenant include a percentage rent provision in the lease, they agree implicitly that sales occurring within the market territory of the store will be included in the gross sales of the store for percentage rent purposes, unless that tenant opens another store within that market area.
Tenants incur a variety of expenses to open a new store, which may include those for constructing a building or tenant improvements, fixturing, stocking of merchandise, employees, utilities, insurance and real estate taxes. The tenant usually pays minimum rent and percentage rent to the landlord of the new store. It is not surprising that many courts have held that, in the absence of a specific lease provision to the contrary or an intent to divert sales, sales from the new store are not included in gross sales of the original store, even if arising in the same market area.
The necessity for tenant investment in a new store, what could be called an implied covenant of capital investment, has traditionally served as a safeguard against the diversion of sales from the store. Although development of a global retail Web site can be costly, the Internet enables retailers to make sales within the market area of the original store without the capital investment expenses and risk associated with opening a new store. Thus, retail Web sites divert sales from the store and cause a corresponding reduction in percentage rent in circumstances that the parties did not intend. Because the operation of retail Web sites violates this implied capital investment covenant, a portion of the sales from the Web site should be included when calculating percentage rent.
The reason for including Internet sales in percentage rent is not because the parties contemplated specifically that they be included, given that the technology is so new it was unknown only a few years ago. Instead, the reason for including Internet sales is that to exclude them would violate the implied intent of the parties.
If a court relies on an implied covenant of capital investment and concludes that Internet sales within the market area of the store should be included in gross sales, it must also identify that area and the Internet sales that occur within it. If the lease includes a specific prohibition on competing stores within a stated radius of the leased premises, that radius could be used as the area for Internet sales to be included. Otherwise, the area may be established through discovery and testimony, based on market analysis and data that the tenant considered in deciding to open the original store.
Internet Sales Provision for New Leases
New leases should state specifically whether Internet sales are included for percentage rent purposes. Whether Internet sales are included in the percentage rent provisions of new leases will be a purely economic issue that the landlord and tenant decide based on their negotiating leverage and how badly each wants the deal. Because the technology is now known, a failure to address Internet sales in new leases may lead a court to recognize an implied intent of the parties to exclude such sales. If the parties agree that all Internet sales should be excluded, the lease could state the following:
Notwithstanding anything set forth herein to the contrary, all revenues relating to goods or services sold through Web sites on the Internet shall be excluded from the definition of Gross Sales and not included when calculating percentage rent pursuant to this Lease, regardless of the place of delivery.
A percentage rent clause often excludes all refunds for merchandise returned to the store from the definition of gross sales. If Internet sales are excluded initially from the definition of gross sales, then there should be no exclusion for store refunds relating to Internet sales. Additionally, gift certificates purchased on the Internet should still be included in the gross sales of the store at which they are redeemed.
Landlords and tenants who agree that Internet sales should be included in gross sales for percentage rent purposes must identify those sales in a way that is logical, simple and practical. They could identify sales based on information that the tenant receives and retains from Internet purchasers. On-line customers usually pay by credit card and provide a billing address with zip code. Once the address and zip code of an on-line purchaser are known, one can determine whether that purchaser resides within a specified geographic radius of a particular store. On-line data and mapping software can pinpoint the customer locations. An Internet sales area could be delineated by reference to zip code zones. It may not be appropriate to include all Internet sales within a particular zip code zone if it overlaps the market territory of different stores operated by the same retailer. In that circumstance, the sales from that zone could be segregated according to the street addresses of the customers. A definition of gross sales including Internet sales could state the following:
Gross Sales include all sales from Tenant Web sites or pursuant to e-mail solicitations within the Internet Sales Area, as those terms are defined below. A sale shall be deemed to occur within the Internet Sales Area if the billing address of the purchaser is located within the Internet Sales Area, regardless of where the merchandise is delivered.
The lease could define the term "Tenant Web Site" as follows:
A Tenant Web Site is any Web site on the Internet operated by Tenant or any affiliate thereof, directly or with the assistance of another entity, that: (a) uses the same or a similar trade name as the trade name used by Tenant; or (b) offers for sale or lease goods or services of the same or similar type as those offered by Tenant.
The lease could then define "Internet Sales Area" as follows:
The Internet Sales Area for the Premises is comprised of U.S. Postal Service zip code areas [specify] as they exist on the effective date hereof. If the U.S. Postal Service changes or discontinues use of, or redesignates the foregoing zip code areas at any time in the future, Landlord may select new U.S. Postal Service zip code designations that approximate the geographical area included in those referenced above or establish such other method of defining that geographical area as it may deem appropriate in the exercise of its sole discretion.
A sample provision for reporting Internet sales follows:
Tenant shall maintain accurate records of the names, individual sales billing addresses and zip codes for all customers for sales from any Tenant Web Site for a period of at least four years after the date of sale. Such records shall be made available to Landlord on request. As part of its annual report of Gross Sales and payment of percentage rent, Tenant shall include all revenues from sales for which orders were placed on a Tenant Web Site by purchasers with billing addresses within the Internet Sales Area.
A landlord and tenant should also consider whether the tenant must report Internet sales independently of sales occurring at the leased premises or combine them with those sales when it reports gross sales for percentage rent purposes. If the tenant maintains separate records for Internet sales within the market area, a separate breakpoint or percentage rate could be used for Internet sales instead of the breakpoint and percentage used for sales occurring at the store.
In the past, retailers selected the best locations for their stores to maximize sales. Landlords controlled those locations and shared in the increased sales through the receipt of percentage rent. Store locations are still important, and percentage rent should not be reduced by the diversion of sales to retail Web sites. Nonetheless, the importance of store locations will decrease as the popularity of Web sites increase. Although the use of Web sites for the sale of merchandise threatens percentage rent now, the gradual decline in the importance of store locations may be what ultimately kills percentage rent in the future.
Stephen W. Snively is a partner with Holland & Knight LLP in Orlando, Florida, and is a member of the Real Property Division's Retail Leasing (K-2) and Title Insurance and Surveys (C-2) Committees.
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