When comparing various commercial real estate (office, retail, or warehouse space) locations for lease or rent most business owners and companies typically compare locations based on 7 common measurements:
- Monthly Rent
- Yearly Rent
- Total Lease amount over the term
- Effective rental rate (in Sf) for the entire lease term
- Rental Cost per square foot
- Occupancy cost per person
- Square feet per person
Ratio of Annual Sales (Revenue) to Annual Rent
A benchmark that is increasingly being used by business decision makers is the rent to sales (revenue) ratio to measure the impact of the cost of leasing commercial real estate space (office, retail, or warehouse). This is also sometimes known as the occupancy cost ratio. The base rent to sales ratio is a great way to decide if a location makes economic sense to rent. This rent to sales ratio will vary from 2% to 20% depending on the type of business you are in. For example retailers should target a base rental rate that is no more than 5% to 10% of gross annual sales, where a law firm may find a rent to revenue ratio of 15% acceptable.
How do You Calculate the Rent to Sales Ratio?
**Company’s find this ratio by dividing the annual base rent or gross rent by the forecasted yearly sales. **
If you forecasted $1,000,000 in sales for the year for your restaurant and your base rent is $9,000 per month, the base rent to sales ratio would be 10.8% ($9,000 x 12 = $108,000 / $1,000,000). This would be considered an expensive location since to lease retail space additional expenses need to still be factored in such as taxes, insurance, and maintenance (aka CAM or NNN). Some retail centers would also charge tenants a portion of their advertising into the rental costs. In some cases it would make sense to calculate the gross occupancy cost ratio by dividing the total annual gross rent by the annual gross sales.
Why do Companies Use this Metric?
The reasoning behind using this measurement is that it gives decision-makers an understanding of how to make choices about the right amount of revenue to spend for commercial space at different sites. Also, if a site is worth the extra expense, increased income generated at that site will validate the added cost. In the past, businesses have looked at commercial space leases as an uncontrollable cost of doing business and have not compared a worksite’s profit to the cost of occupying the site. Often, businesses have gone under when operators did not take the time to think about what would happen if they lost their one big client. When that day arrived, these businesses were driven out of operation because their remaining clients could not support their exorbitant operating expenses. Today, more organizations realize that the cost to lease a workspace is part of financial planning.
Where Can I find Historical Data on Industry Rent to Sales Ratios?
The method is very common now, and most businesses, industries and regions have a history of data to show them what their rent to revenue numbers should look like. There is no ideal level for a company’s rent to sales ratio because the bottom line is influenced by a number of other factors, however there are companies that report average industry financial ratios such as Bizminer. Firms must analyze their individual circumstances and decide what actions make sense for the financial health of their organization. Company accountants should view this expense as part of the company’s overall expenses, such as debt, wages and taxes.
If a business’s rent to revenue ratio is low, then it is better positioned to remain stable in the event of market fluctuations in inventory, staffing or demand costs. On the other hand, if a business’s rent to revenue ratio is high, they may need to negotiate a lower rent or lease agreement. If the property manager has several empty units, and businesses can go elsewhere and find sites with similar volumes of foot traffic, renegotiating a lower rent may be as easy as asking for it. When the retail commercial space market is performing poorly, business owners may be able to negotiate rent reductions. Overall by calculating the rent to revenue ratios on each property you will be equipped to make better commercial real estate decision.