Cap Gross Sales Exclusions that May Generate Profit for Tenant

Percentage rent leases commonly permit tenants to deduct or exclude certain kinds of transactions that don’t generate a profit for the tenant from the gross sales on which percentage rent is due. Typical examples include revenues from gift wrapping, deliveries, repairs to items purchased from the tenant, and discount sales to employees. The problem is that these services and sales may, in fact, generate significant revenue and profits. So, allowing tenants to categorically deduct or exclude (for simplicity’s sake, we’ll refer to exclusions and deductions collectively as “exclusions”) them from gross sales could end up costing you big bucks.

Loophole: Excluded Revenue May Be Profit Center for Tenants

A California leasing attorney relates how one of her landlord clients got burned by agreeing to give a retail tenant a common exclusion carving out discount sales to employees from the lease definition of “gross sales.” We don’t make any real profit on these sales, the tenant claimed. Lots of other retailers can make the same contention about the discount purchases made by their own employees.

But the tenant in this case was a store that sold flashy clothes at low prices to mostly teenage customers. It just so happened that the tenant’s employees were also predominately teenagers, ones that liked to spend their paychecks buying flashy discount clothes. In addition to buying large quantities of clothing for themselves, these employees used their discount to purchase store merchandise for their friends. Even at a discount, these sales were generating significant profits for the store. But because it had agreed to let the tenant exclude employee discount purchases from gross sales, the landlord didn’t collect any percentage rent on these sales. 

Solution: Put Caps on Gross Sales Exclusions

Protect yourself against missing out on percentage rent by putting a cap on exclusions from gross sales that represent a potential source of profit to the tenant, attorneys advise. Specify in the lease that if the excluded transaction constitutes more than a set percentage of the tenant’s gross sales—say, 3 percent—the overage must be included in gross sales. In addition to preventing tenants from not paying you a fair share of the unforeseen profits they reap via use of the leased space, this approach can be an effective compromise in a situation where a tenant demands an exclusion that you don’t want to give.

Example: For only a nominal charge, a jewelry store tenant makes repairs to the items it sells to customers. The lease excludes these customer service repair revenues from the tenant’s gross sales to the extent those revenues don’t exceed 3 percent of gross sales for the period. In July, the tenant reports gross sales of $150,000. Customer service repairs revenue for the month is $5,000 due to an unexpected surge in demand for watch repairs. The tenant is allowed to exclude only $4,500 ($150,000 x 3%) for customer service repair revenue and must include the remaining $500 as gross sales subject to percentage rent in July.     

Negotiating Strategy

You’ll probably have to negotiate the terms of the cap with the tenant, including the cap amount of each exclusion. While caps may vary depending on the type of exclusion involved and nature of the tenant’s business, experienced attorneys say they should be somewhere in the range of between 2 percent and 5 percent. Of course, tenants will want the percentage to be as high as possible.

While amenable to the concept of caps, attorneys caution that tenants generally won’t accept an overall cap on the sum of the exclusions. That’s because some common exclusions, such as sales tax and refunds to customers for returned merchandise, could never generate even a small profit. So, tenants will argue that you shouldn’t include any part of these types of exclusion in gross sales.

Leasing Strategy

How you draft the cap provision will depend on the kind of exclusion involved. Here’s some model language you can use to cap an exclusion of employee discount sales from a tenant’s gross sales:

Model Lease Language

In addition to the exclusions from Gross Sales specified in the Lease, the following shall be excluded from Gross Sales:

(i)              Sales made to Tenant’s employees at a discount to the extent that such sales do not exceed three percent (3%) of Gross Sales during any reporting period;

(ii)            [List other exclusions subject to the cap and their respective cap amount].

Final words of advice: Make sure that the tenant gives you an itemization of all excluded transactions in its monthly sales statement, and not just the gross sales amount net of exclusions. You need to know about all the transactions occurring in the store, not just those the tenant counts towards gross sales. Without this information, you won’t be able to determine if the tenant has exceeded its cap.