How Variable Lease Works in Retail?

Leasing has traditionally been one of the biggest expenses related to the retail industry. This expense is incurred by almost every retail company across the world. However, over the years, retail companies have found it problematic to pay a fixed lease to landlords. This is because such lease agreements create operational leverage on their balance sheets.

In the competitive environment of today, retail companies need to be lean. Their cost structure should be such that their expenses increase and decrease as per the conditions prevalent in the external market.

It is for this reason that retail companies across the world have taken innovative steps to resolve the issue. One of the innovative steps which has been taken is called the variable lease.

The variable lease is an arrangement whereby the retail company does not directly commit a fixed rental to the landlord. Instead, an arrangement is drawn up whereby the landlord receives rentals based on the percentage of sales which have taken place at that particular property.

This article provides more details about variable lease arrangements.

What is Variable Lease?

A variable lease is basically a risk and reward sharing arrangement between retail store owners who lease commercial premises as well as the landlords. As a part of this arrangement, retail companies do not pay a fixed rent irrespective of their market sales. Instead, they pay a variable rent which is based on their sales.

Hence, if the sales in a particular month are high, then the lease rental paid in that month will also be high. On the other hand, if the sales drop for unforeseen reasons such as the Covid-19 pandemic, then the rental due that month will also reduce significantly.

Variable lease, also known as percentage-based lease, has been touted as an innovative arrangement which resolves the adversarial relationship between the retail company and the landlord. This arrangement ensures that the incentives of the landlord are aligned with that of the retail company. The end result is that both parties start co-operating with each other instead of trying to benefit at the expense of the other.

How Does Variable Lease Work?

In order to understand the working of variable leases, it is important to understand three important concepts related with it. These concepts are base rent, breakeven point and variable rent. The details of these concepts have been mentioned below:

1. Base Rent: Every variable lease contract has a base rent. This is the amount of rent which is required to be paid to the landlord regardless of whether or not any sale has taken place. This base lease is set quite low to ensure that it is fair and equitable to both parties.

   The base rent ensures that the landlord will receive some fixed amount of rental income regardless of the situation. The presence of this base rent gives landlords the financial cushion required to enter into sales-based agreement.

2. Breakeven Point: The base rent mentioned in the above point is applicable till a particular level of sales has been reached. This point is called the breakeven point. The breakeven point decides when the fixed minimum rental being paid by the company becomes irrelevant and the provisions of variable rent kick in. This can be best explained with the help of an example.

   For instance, if the base rent of a commercial location if $1 million and the incremental rent is 5% of sales, then ideally the breakeven point should be $20 million. This is because $1 million is 5% of $20 million. Hence, this is the natural breakeven point.

   It is also possible for the landlord and the retail company to agree upon an artificial breakeven point which might be higher or lower than this amount. This depends upon the demand and supply situation present in the market at any point of time.

   Setting the right breakeven point is essential for the success of the leasing arrangement. The variable point should be close to the average sales which the store is expected to achieve each month. If it is too high, then the retail company will end up paying the same rent as a fixed lease and the whole purpose of variable lease will be defeated. Is the breakeven point is set too low, then the retail company may end up paying a significantly higher rent which may incentivize them to end the contract.

3. Variable Rent: The last component of the variable lease contract is the variable rent itself. Once the breakeven point has been reached, the retail company then pay a percentage of the incremental sales as rent to the landlord.

   For instance, in the above example, if the breakeven point was set at $20 million and sales worth $28 million were made, then the retail company will have to pay a percentage of $8 million as variable lease. It is common for retail companies to pay a higher percentage of their sales as lease once their sales go beyond a point.

   For instance, in the example above, the retailer may agree to pay 5% of the sales as lease till the total sales reach $40 million. Beyond that, they might agree to pay 6% of the sales as lease. This is done to incentivize the landlord so that they provide more support and a higher total sales target is reached.

It can be said that the variable lease concept is an innovative way of spreading the risks and rewards evenly between the landlord and the retailer. This concept has many pros and cons. We will have a closer look at some of these pros and cons in the next article.