The Value of Percentage Rent in Long-Term Ground LeasesJuly 2019 – National Real Estate Investor
The higher potential returns of percentage rent may make it a worthwhile lease model for landlords.
A principal challenge inherent in long-term ground leases is that they are contracts to be performed over an extended period. Ground lease terms can be as long as 99 years or even longer, and the lease must make provisions for market changes and events that will not occur until many years in the future. A major issue in the context of long-term ground leasing is the way ground rent will be adjusted over the term of the lease. At the outset, the ground rent is established by the parties (generally by applying a capitalization rate to the parties' determination of the fair market value of the land). Similar to space leases, the fixed rent may be subject to periodic fixed increases (e.g., 2 percent every year). However, there will come a time during the term of the ground lease when the fixed increases in the ground rent begin to erode the value of the rent. To address this, most ground leases will provide (in addition to fixed increases) for one or more adjustments to the ground rent at stated intervals based on the fair market value of the land at the time in question. The deficiencies in this method of adjusting ground rent are numerous and have been widely discussed, but principal among these concerns is the lack of predictability which some tenants believe render their leases unfinanceable and/or unmarketable.
While fair market value resets remain ubiquitous in ground leases and are likely to remain so, another interesting but less common approach to revaluing ground rent is the use of percentage rent, implemented in the same manner as with shopping center leases. Percentage rent works by applying a percentage rate to the annual revenue from the project, which could be the gross revenue, income before debt service, net operating income or other formulations based on revenue and might apply to the total revenue or only the revenue above an agreed upon threshold. As with the fair market value adjustment, the goal of percentage rent is to provide a return to the landlord that reflects the contribution of the land to the project. In the context of a ground lease, percentage rent should reflect increases in the market without bringing the rent to a level having no relation to the revenue being produced from the project. It also provides the landlord with an opportunity to participate in the profits of the project, making this an appealing option in certain situations. The simplest approach is to apply a percentage to gross revenue rather than net revenue without any threshold. Using gross income also avoids fluctuations that are a function of variable operating expenses and the potential for disputes over the tenant's calculation of net operating income.
The landlord's goal is to capture every item of income that is generated at the property, while the tenant must consider which amount that might otherwise be included in gross revenue should be excluded for purposes of determining percentage rent. Payments that do not reflect the income from the project can include reimbursements from space tenants for operating expenses and real estate taxes, payments for electricity and other utilities, and insurance proceeds (other than business interruption insurance). To be safe, a tenant may prefer to start with cash flow after debt service (or even after priority returns). This will likely be too uncertain for the landlord to comfortably agree on what percentage should be applied and may result in the landlord placing limits on financing amounts.
If percentage rent is based on net operating income, then the landlord is assuming the risk of not only the performance of the business, but also the tenant’s skills in managing the business. The landlord must look out for excessive fees paid to a tenant-affiliated management company and professional fees that are not directly related to operating the property.
The net operating income approach begins to resemble a joint venture. Calculating percentage rent is more cumbersome than other types of rental payment structures, requiring the landlord to monitor the tenant's activities and performance. For example, since percentage rent provides the landlord with a return on the income from the project, the landlord will need to ensure that the tenant is operating the project in a manner that will maximize revenue. Accordingly, minimum operating requirements and restrictions on operating competing businesses within some radius of the property may be included in the lease. Space that is leased to an affiliate of the tenant at a below market rent (other than an appropriate management office) should be "grossed up" to the fair market rent for the space. The lease will also need to include a reporting and payment process to which the tenant must adhere. Most leases require that statements of gross revenues be submitted to the landlord together with estimated payments because of percentage rent on a monthly or quarterly basis. with an adjustment after the end of the year once the tenant determines the amount of gross revenue that was actually produced.
Risk equals reward
Traditionally, landlords expect a steady predictable income and do not assume risk related to the success of the business operated at the property. However, in a percentage rent scenario, the landlord also participates in any upside and may enjoy higher returns that are associated with this risk. When executed well, the return could exceed the actual value of the land for the project. The tenant also bears certain burdens of the de facto partnership with the landlord, including the obligation to make its books and records available to the landlord for examination to confirm that the tenant has paid the correct amount. The additional work might just be worth dealing with to alleviate concerns about the unpredictability of fair market value resets.
This article originally appeared in the July 15, 2019 edition of the National Real Estate Investor.