Although views on the future of retail change daily, most observers acknowledge that success in retail requires meaningful engagement with one’s customers through many channels, including on-line, on mobile devices, and within physical stores. This “omni-channel” approach, as it has become known, relies heavily on data and aims to meet customers where they are. But, what does all of this mean for retail real estate? Recent trends in the retail industry call for re-evaluating the traditional percentage rent concept found in many retail leases.

In a recent report published by McKinsey & Company, the authors described retailers’ traditional approach to real estate and how that approach is changing:

“For decades, the retail industry has followed the same straightforward formula for growth: open new stores. By replicating a proven store format in a new catchment area, retailers could reliably enlarge their customer base and count on healthy increases in sales.

But the world has changed. More than half of consumers now research their retail purchases online, making purely in-store purchase decisions the shrinking minority. In many categories, e-commerce has dramatically lessened the need for physical stores.”¹

As evidence of this assertion, the authors cite the closure of 250 Gap stores and almost 200 Sears stores in 2013 in the United States,²  as well as the shrinking store footprint of such retail powerhouses as Walmart.³

Despite these figures, the article does not go on to foreshadow the end of retail real estate. To the contrary, the authors warn against the impulse of “shrinking to greatness”⁴  and encourage retailers to, instead, shift from a “store-focused approach to a multi-channel mindset”⁵   in which retailers reassess the role of physical stores and execute across all available channels. In fact, the article states unequivocally that “the brick-and-mortar store is not dead, it just plays a different role now.”⁶

This sentiment is shared by Devin Weinig, the President of eBay Marketplaces, one of the world’s largest online markets. In an interview with McKinsey Publishing’s Simon London, Weinig states that the “death of the store has been greatly exaggerated.”⁷   He goes on to say that he does not envision a future that is limited to e-commerce because customers do not want that kind of future.⁸   Weinig opines that people like to shop – they like to be entertained, engaged and inspired.⁹

However, the role of the physical store is changing and will continue to change. According to Weinig, “Stores are going to become as much distribution and fulfillment centers as they are full-fledged shopping experiences . . . stores and malls are going to be highly technology enabled.”¹⁰  Thus, Weinig concurs that physical stores will continue to play an important role in the overall consumer experience, while he observes that the retail stores of today are rapidly changing and are part of a multi-faceted approach to retail that relies on physical space and e-commerce, among other channels:

“. . . I think there are going to be stores, and I think that retail real estate is not dead, but it is going to transform, and it’s going to happen faster than people think. Within 24 months, you will see a fundamental restructuring of retail real estate – you will see distribution centers, local economies, technology-enabled shopping, and a very different approach to how you engage with the consumer.”¹¹

Despite all of this change, the principles of successful retail real estate seem constant – successful retail real estate requires effective retailers. In a recent interview, Art Coppola, CEO of shopping center REIT Macerich, said:

“The dot-com world and the catalogue world has been a source of great new retailers for our shopping centers, both in the past as well as the future. There are a number of retailers that were born in the catalogue world that now are some of our best brick-and-mortar retailers. There are Internet retailers that were born digitally, that now have great retail stores with us. There are digital pure-play retailers that never intended to have brick and mortar stores that have recently figured out that they need to have brick and mortar stores in order to really maximize their brand.”¹²

Set against this backdrop of the changing role of retail real estate, one open question facing landlords is whether and how to capture online sales for purposes of percentage rent. If the store of the future is a distribution center, or a venue in which to touch and feel a particular product and receive recommendations, or a fulfillment center, or some combination of the foregoing, how will this affect our traditional understanding of gross sales and percentage rent?

A percentage rent clause in a retail lease requires the tenant to pay a portion of its gross sales to the landlord. Tenants and landlords of all sizes and across a variety of retail segments are familiar with the concept of percentage rent. A typical percentage rent provision requires the tenant to pay, in addition to base rent, a percentage of all gross sales achieved by the tenant in excess of a negotiated amount, often referred to as the gross sales “breakpoint.” For instance, a lease might provide that the tenant will pay to the landlord, as percentage rent, an amount equal to 5% of all gross sales generated by the tenant over $2,800,000. In this case, if the tenant’s gross sales for a lease year are $3,800,000, then the tenant would pay to the landlord, as percentage rent, 5% of the difference between $3,800,000 and $2,800,000, which would come to $50,000.

In addition to negotiating the gross sales “breakpoint”, the determination of what kinds of sales should be included in the definition of “gross sales” for purposes of percentage rent is also fertile ground for debate and negotiation between the landlord and the tenant. It is squarely within this battleground area that the issue of e-commerce falls.

Although the relative negotiating power of the two parties will weigh heavily on the outcome of this discussion in particular leasing transactions, below are some considerations and trends that are playing out in this changing environment.

One important question is to what extent did the sale “touch” the physical store? Subject to certain well-defined exceptions, it is generally accepted that sales made from the physical store should be included in gross sales for the purpose of calculating percentage rent. However, consider these transactions:

• A customer orders a product online from a tablet or computer situated within the retailer’s physical store and takes delivery of that product at her home.
• A customer purchases an item online from the retailer’s website and takes delivery of the item at the retailer’s physical store.
• A customer walks into a store, tries on a jacket, and then leaves the store and orders the item from his tablet or phone (on the walk home) and takes delivery at his home.
• A customer orders an item online from a retailer’s website and takes delivery at his home without ever visiting the retailer’s physical store. Does it matter if the product was shipped from a central warehouse? What if the product was inventory at a retail store and shipped from that store to the customer’s home?

These are just a few examples of transactions that are turning the traditional percentage rent model on its head. They also demonstrate a continuum – The situation in which the online sale is generated from a computer within the store more clearly “touches” the physical store than does the case in which the consumer relied upon the physical store to make a purchasing decision (i.e., trying on a jacket) but consummated the sale from his home via the retailer’s website. The point along this continuum at which a given transaction falls will determine whether the sale is included in gross sales for purposes of calculating percentage rent.

Larger landlords, recognizing both that an omni-channel approach is critical to the success of their retailers and also that physical space continues to play an important role in the equation, have taken the position that if the physical store in their shopping center “is any part of the distribution channel for [the] sale, it’s going to count in our sales.”¹³

To that end, some of the larger landlords have crafted percentage rent provisions that include as gross sales all goods sold at, in, or from the leased premises, including sales made on the internet. A sample lease provision might include in the definition of “gross sales” the following: “sales prices from all goods sold at, in or from the leased premises pursuant to internet or other technologies (now or hereafter developed), or otherwise received, placed or filled at the leased premises.” This language attempts to cover both the situation in which the customer makes his internet order from a computer situated within the leased premises, as well as the case in which the customer purchases a product online from outside of the leased premises, but the order is shipped from, or picked up at, the leased premises. In some leases, landlords have attempted to reach internet sales more broadly by defining gross sales as “any sale that originated at the leased premises”. Querry whether this broader language would cover the transaction in which a customer visited a store to try on a jacket, made his purchase online from his home computer, took delivery of the item at his home, and the retailer shipped the jacket from a centralized warehouse (not the leased premises). Even if the broader “originated at the leased premises” language could be interpreted to cover this hybrid sale, the challenge will be documenting the role of the physical store in the transaction.

This leads us to another important consideration, which is how today’s retail transactions are being documented and whether traditional landlord audit rights are sufficient to track non-traditional transactions in which the physical store plays a more limited or different role than in the past. Traditional percentage rent clauses in retail leases require the tenant to record all sales at the leased premises by use of specific cash registers or similar technology to track sales. More sophisticated leases will require the tenant to provide gross income and sales tax returns as well as sales journals and inventory records, to enable the landlord to monitor the movement of goods in and out of the store. These clauses also often give the landlord the right to audit the tenant’s books and records to verify the tenant’s gross sales statements. Given the complexity of the transactions described herein in which the consumer may or may not have set foot in the physical store, it is clear that landlords and tenants will want to re-evaluate existing leases and lease forms to determine whether the gross sales reporting requirements and audit rights contained therein are broad enough to provide a clear picture of whether and how the particular store was involved in a given sales transaction.

Like any other disruptive technology, e-commerce has certainly shifted paradigms and changed the way consumers interact with retailers. One of the challenges for landlords and tenants as retail continues to evolve will be to re-think percentage rent and to craft provisions that account for the role of the physical store in the broader omni-channel retail reality in which we are now operating and ensure that the tenant’s record-keeping and reporting requirements are sophisticated enough to measure the physical store’s involvement in a sales transaction.

^{1 Louise Herring, Tobias Wachinger, and Chris Wigley. “Making stores matter in a multichannel world.” McKinsey & Company, December 2014: page 1.
2 Id. at page 1.
3 Id.
4 Id. at page 2.
5 Id. at page 3.
6 Id.
7 Simon London, “How digital is transforming retail: The view from eBay.” McKinsey & Company, July 2014.
8 Id.
9 Id.
10 Id.
11 Id.
12 Mark Heschmeyer. “Eking out e-retail rents from e-commerce, shopping center landlords redefine portfolios as retailers blend brick-and-mortar stores with online sales.” CoStar Group, February 12, 2014. http://www.costar.com/News/Article/Eking-Out-E-Retail-Rents-from-E-Commerce/157300.
13 Id. (quoting Richard Sokolov, President and Chief Operating Officer of Simon Property Group)}

BIBLIOGRAPHY

Herring, Louise, Tobias Wachinger, and Chris Wigley. “Making stores matter in a multichannel world.” McKinsey & Company, December 2014.

Heschmeyer, Mark. “Eking Out E-Retail Rents from E-Commerce, Shopping Center Landlords Redefine Portfolios as Retailers Blend Brick-and-Mortar Stores With Online Sales.” CoStar Group. February 12, 2014. http://www.costar.com/News/Article/Eking-Out-E-Retail-Rents-from-E-Commerce/157300

Wenig, Devin. How digital is transforming retail: The view from eBay. By Simon London. McKinsey & Company, July 2014.