Limit Tenant's Profit-Sharing, Percentage Ownership Rights

Although the commercial real estate market is steadily improving, tenants still are negotiating aggressively for lease terms that they otherwise wouldn't have been able to get before the downturn. During that time, most national tenants—whether or not they were struggling—asked their owners for rent abatements. But some tenants with a lot of clout asked for either a profit-sharing or a percentage ownership agreement—rights that can be much more lucrative.

Before allowing a tenant to take a share of your profits or enjoy percentage ownership of your shopping center or office building in exchange for something they will give you only if you agree to those arrangements, such as a long-term lease, consider these factors. And if you agree to one of these arrangements, be very careful about how much latitude you give the tenant in exercising its rights under them.

Weigh Benefits and Risks

Percentage ownership and profit-sharing rights should be given only to major tenants that are offering something very valuable. “Typically, an owner would want to make these types of deals with a tenant that can give it something in return that would make it worth giving up a share of the owner's profit or property,” notes Atlanta real estate attorney Jeremy D. Cohen. Giving these rights to an insignificant tenant would defeat the purpose of an agreement: to attract or retain a key tenant that otherwise wouldn't rent space from you.

A percentage ownership arrangement is attractive to the tenant because it presents an opportunity to invest in a property, without having to provide a lot of capital. Rather, the tenant can use something like a long-term lease as an incentive for the right. A percentage ownership arrangement can be undesirable for an owner that already is running a successful shopping center, but is forced to make such a deal because it can't afford to lose that specific tenant; the arrangement gives the tenant power over the owner that can cause tension later on.

But an owner that's developing a retail property can benefit from a percentage ownership arrangement when it gives part of the land to be developed for free to a national tenant, ensuring the success of the shopping center it is building around that popular anchor tenant. “The benefit of giving a tenant a share of the property for free is that the owner has a much better chance of having a successful development,” says Cohen. “The tenant is committing to a long-term deal whereby it helps the rest of the center,” he adds.

A profit-sharing agreement, under which you would be required to give the tenant a percentage of the profits you make from operating your property, can be risky. It isn't a new idea in commercial leasing. In fact, many leases require the tenant to give the owner a piece of its profit if it sublets or assigns its space for more rent than it was paying. But sharing your profits gives a significant right to the tenant.

“Once you give a tenant profit sharing, you're tied to that tenant,” Cohen warns. “You have to give the tenant the right to go through your books to audit whichever information will enable it to determine where you are making or losing money,” he adds.

A tenant that becomes a partner will want to know how the bottom-line profit that it has a right to has been made and calculated. “By giving a tenant the right to audit your books, which you almost never want to do, you're giving it the right to question how you're managing the property,” notes Cohen, a partner at Hartman Simons & Wood LLP.

When your tenant questions you about what you're putting into the property, you'll be forced to explain why you're giving certain tenants things like higher construction allowances than the profit-sharing tenant thinks are appropriate. This could diminish your profits if you have to revamp decisions as a result.

PRACTICAL POINTER: Offer your tenant an alternative to typical profit-sharing (where you have to worry about audit rights and calculation of profits) or percentage ownership agreements, by giving the tenant “ownership of leasing the building.” Instead of giving the tenant a share of the profits, offer to reduce rent as long as a specified percentage of the building or center is leased. This also benefits you because it creates a vested interest for the tenant in making the center look better to lease it more easily.

Set Limits on Agreement

“Giving a tenant the right to even question things like how you're managing the property or why its share wasn't bigger creates headaches that you want to avoid—unless that's the only way you can make a deal with that tenant work,” advises Cohen.

But if you've decided to make an agreement with a tenant, negotiating limits on these key profit-sharing or percentage ownership rights in the lease could stop your agreement from turning into a bigger problem than it's worth.

Audit right. Make sure to negotiate profit sharing without audit rights. “The tenant will want some way to verify that it's not getting cheated, but you absolutely should limit things like audit rights,” says Cohen. “When you are heading down the slippery slope of giving a tenant these rights, the heaviest negotiation is going to be over how profit is determined,” says Cohen. He recommends trying to use a sliding scale for payment amounts, so that the percentage of annual profits due to the tenant can rise or fall over the course of the lease term, depending on the terms you've agreed to.

If the tenant is not getting a payment, it can audit your books. But if the tenant is making a certain percentage from the deal, it should have no right to audit. First, set a range for the sum of profit-sharing payments within which there is no right to audit. Second, specify that a payment of profits that is less than a set percentage or dollar amount triggers the tenant's audit right. Ask your attorney about using this Model Language:

Model Lease Language

Tenant shall have no right to audit Owner's records as long as profit paid to it is between [insert #, e.g., three (3)] percent and [insert #, e.g., five (5)] percent. Tenant shall have the right to audit Owner's records if Tenant's share of Owner's profit is [insert #, e.g., two (2)] percent or less.

Calculation right. When an owner is entitled to share a percentage of its tenant's profits, the tenant has a straightforward metric to calculate them; the tenant has a certain amount of inventory and a certain amount of sales, making it easy to figure out its profit from that information. But there isn't a similar metric for an owner's profit.

Specify that net profit will be determined after your costs and expenses in connection with the development, operation, leasing, and management of your property are subtracted from the total revenue generated by the property. Include a list of items that are to be deducted from total revenue so that there is no confusion later about why certain expenses have reduced the tenant's share.

Don't forget that calculating the amount you owe to your tenant may take time. Try this Model Language to carve out a reasonable time to pay the tenant its share of the profit. Allot enough time for you to handle all the administrative details, such as calculating the profit.

Model Lease Language

Provided that Tenant shall not then be in default of any of Tenant's monetary or material nonmonetary obligations under this Lease, Landlord shall pay to Tenant, within [insert #, e.g., thirty (30)] days after sums on account thereof are due from Landlord's profits as defined in Section [insert section #] of this Agreement an amount equal to Tenant's share as defined in Section [insert section #] of this Agreement.

Don't try these agreements unless it's totally necessary. What the tenant is offering or what you need from it must be important enough for you to take on the risk. “At the end of the day, if you're going to give a tenant an ownership interest in the overall project or a share of your profit, you absolutely should insist during lease negotiations on limiting the tenant's rights,” says Cohen. “It's no longer a tenant really; it's a partner,” he emphasizes.

Insider Source

Jeremy D. Cohen, Esq.: Partner, Hartman Simons & Wood LLP, 6400 Powers Ferry Rd., NW, Ste. 400, Atlanta, GA 30339; jeremy.cohen@hartmansimons.com.