Is percentage rent viable in an omni-channel world?

Percentage rent

For many years, percentage rent has been a core element in the shopping malls’ business model. Shopping malls’ operators often include in their leases a percentage rent clause that requires tenants to pay them a percentage of gross sales, subject to a minimum payment in the form of a base rent. The viability of this clause is contingent on the accuracy of the reporting of gross sales by the tenants. Over the years, mall operators relied on the tenants’ periodic reporting of sales, and on an audited sales report, usually submitted on an annual basis. With the advancement of technology, new reporting tools became available and are now used by mall operators. These can range from the submission of automated daily sales reports generated by the tenants’ systems, without human intervention, to complete integration of the tenant’s point of sales with the lessor’s systems, enabling the landlord to have real time access to the tenant’s sales data.

Issue

Recent years have seen a shift in the business model of retailers. Whilst brick-and-mortar remains important, retailers are moving to an omni-channel model in which online sales play a key role. This transformation was driven by the advancement of technology and a shift in customers’ behavior which accelerated during the pandemic. The shift to an omni-channel world creates multiple situations in which certain transactions have a partial connection to a physical shop, posing a question of whether such limited connection justifies the inclusion of the transaction in the gross sales of the shop for the purpose of computing the percentage rent.

Consider the following transactions conducted by a retailer engaged in fashion or apparel trading:

1. a customer purchases a product online from the retailer’s website and takes delivery of the product at one of the retailer’s physical shops.
2. a customer purchases a product online from the retailer’s website and takes delivery of the products at one of the retailer’s physical shops. Subsequently the product is returned or exchanged by the customer at another physical shop located in another mall.
3. a customer orders a product using a tablet available at the retailer’s physical shop and takes delivery of the product at home.
4. a customer visits a store to purchase a specific product and is directed by the staff to order the product online due to the non-availability of stock.

Consider also the following transactions conducted by a restaurant operator:

1. a customer orders food on a delivery platform and the order is prepared in the kitchen of the restaurant situated in a shopping mall.
2. a customer orders food on a delivery platform from a restaurant located in a shopping mall, but the food is prepared in a central kitchen located outside the shopping mall.

Lease agreements

Landlords often include in their leases a very wide definition of gross sales, which allows to capture all transactions which have a limited connection to the physical shop in the turnover of such shop. Sophisticated tenants often try to challenge such definition and attempt to agree on a narrower definition of gross sales by adding certain exclusions. Negotiation of the definition of gross sales between sophisticated landlords and sophisticated tenants is often intense as it affects the economics of the deal. Whilst the result of such negotiation can often be an agreement based on middle ground, such an agreement is only a step in the right direction and does not necessarily guarantee for the parties the outcome that they both desire. In fact, the matter is more complex, and difficulties will be encountered in executing the agreement.

Reality

The reality is that landlords do not possess tools that allow them to track all the transactions that have some connection to a physical shop if these are not processed through the point of sales of such shop. Consequently, landlords are not able to ensure that they are receiving accurate sales reports that reflect what has been contractually agreed. In most instances, landlords should rely on the tenants’ willingness to voluntarily share such data, which is an unsatisfactory position for the landlords. Moreover, the complexity of the possible scenarios often leads to different interpretations of what is contractually agreed. As a result, the likelihood that the report data will match what is stipulated in the lease will in most circumstances be near to zero.

Open questions

The above leaves the following open questions:

From a tenant’s perspective: in an omnichannel world, where significant sums are spent in developing and promoting the online business, is it fair and appropriate to include online sales, which have a limited connection to a physical shop in the gross sales of such shop? do parties take into consideration the investment made by the tenant in promoting the online business when they negotiate the definition of gross sales and when they agree on the rate of percentage rent?

From a landlord’s perspective: what tools can be used by landlords to ensure that they are receiving accurate sales data that reflect what has been contractually agreed? will technology play a role in developing such tools?

Conclusion

The shift of retail towards omnichannel creates legitimate questions for both landlords and tenants regarding the viability of the traditional percentage rent model. With online sales expected to continue growing over the next years, landlords and tenants will inevitably have to face these questions. This will require an open and collaborative discussion between landlords and tenants with the aim of addressing both parties’ legitimate concerns. It can also be expected that technology will play a role in bridging this gap. At present, and until the gap is bridged, it is likely that the traditional model of shopping centers based on percentage rent will be under check.

By: Rani El Hajjar | Head of Property and Construction at CVML, Dubai