If you stretch a rubber band wide enough, it may break causing physical damage to the body. Similarly, if you stretch the cost factors in the operation of businesses, they may break and weaken the economic infrastructure of the community.
A CPA desires to rent a retail space close to a frequently traveled consumer corridor. He hopes the high foot traffic in the area may help him find customers who are in need of accounting and tax services. He is looking to rent an office space of 2000 sq. ft. The space would need to be large enough to accommodate him, his personal secretary, a receptionist, and two associates. This new location would be cozy but meet all their needs as a small startup accounting business.
The CPA found that comparable rents in the area were in demand and there were no considerations for discounted rents. This is referred to as economic rents. He was able to negotiate a price of $2.50 per square foot per month, or $30. per square foot per annum.
Cozy as it may be, it is adequate costing about $5,000 per month. This becomes a fixed cost for the accounting firm that fully intends to grow into one of the big three. Optimism is healthy and necessary to sustain any capitalist system.
When looking for a rental location some questions to consider would be: 1) The difference between whether the building rent is provided full-service gross, 2) modified full-service gross, or 3) triple net, referred to as NNN?
Are the building’s expenses charged on a prorated basis to the tenant(s) for common areas including hallways, restrooms, elaborate entrances, in the form of pass-through expenses? This is referred to as a Common Area Maintenance (CAM) charge.
- Full-service gross refers to a circumstance where the building owner charges a gross rent amount to the tenants. The owner pays for all operating expenses such as property taxes, property insurance, water, trash, electricity, maintenance, and upkeep including capital improvements, and in most cases includes daily or evening janitorial support.
- Modified gross refers to a circumstance where the owner pays for a portion of the operational expenses but passes on a portion such as property taxes, and property insurances to the tenant. This is generally negotiated up front as an incentive consideration between the owner and the tenant.
- Triple Net (NNN) means that the base rental amount has an additional pass-through charge for all the mentioned expenses in example 1. The landlord will calculate the projection of annual expenses and provide an estimate that the tenant will pay as a monthly CAM charge. The tenant will pay the base monthly rent and the CAM charge in addition. The landlord will periodically balance the difference between the projected and the actual charges and adjust the monthly CAM charges going forward.
How do you determine what your “all-in monthly” and “all-in annual obligation” rent expense will be for your retail location? The first thing is to have the commercial real estate broker who represents you provide an overview of rents in your chosen market area. You will need to get comfortable with rental terms relating to your enterprise. Market rent is what the market will bear. Monthly and yearly total rents per square foot are used for comparison purposes. The rental cost per square foot per month is probably the most common.
Net effective rent refers to a circumstance where the landlord negotiates benefits given to the tenant in the form of rent concessions, tenant improvement allowances, signage rights, cancellation rights, or concessions on expenses for a specified period. Net effective rent is the total amount of net rent the tenant will pay over the term of the lease. For example, a lease may be negotiated at $2.50 per square foot all-in including (NNN) charges. The lessee negotiates 6 months of free rent on the 5-year lease. The months to which the free rent is applied may vary. Your net effective rent is recalculated to reflect that benefit.
Example: Calculate a 5 year lease amount, 5000 square feet at $2.50 base.
Rent without concessions $2.50 X 5000=$12,500 per month X 60 months = $750,000.
Rent with concessions (6 months free) $2.50 X 12,500 per months X 54 months = $675,000.
Note, a negotiated savings of $75,000 will be recalculated to reflect the net effective rent. $675,000 / 60 months will be $11,250 net effective rent.
Net effective cost per square foot is $11,250/ 5000= $2.25 per square foot.
The ratio of annual sales (gross revenue) to annual base rent is a benchmark that is customarily used. This is sometimes referred to as the occupancy cost ratio. The base is calculated as a percentage of the total gross sales. These ratios vary from 2% to 20% depending upon the type of business and the market area. Retailers generally target annual base rental amounts of no more than 5% – 10% of gross sales.
Forecasted gross sales of $1,000,000 for a year and a base rent of $10,000 per month, or $120,000 per year, the base rent ratio would be 10% ($10,000 X 12 months =$120,000/$1,000,000=12%)
In this case, you are spending 12% of gross revenue on rent. In most cases, there are additional charges for property taxes, property insurance, maintenance, and reserves for capital expenditures. It may make sense to calculate your formula using the “all-in” rental amount including the additional CAM charges.
If a business’s rent to revenue ratio is low, then it is better positioned to remain stable in the event of market fluctuations, additional competition, and negotiations for other space. If the ratios are higher than sales volume, the prices must be higher to offset.
I have used $2.50 per square foot monthly or $30 per annum as a norm.
Retail rents that exist in Manhattan, New York are high by comparison with annual rental rates ranging from $600 per square foot to $2,700 per square foot. Those markets have an excess vacancy with no optimism in sight. Some rents have been reduced as much as 40%. What a bargain reducing the rent from $2,700 to a mere $1620! For years Manhattan has been able to charge excessive square foot rents because of the prestige and high-volume characteristic. Other similar areas include Rodeo Drive, Los Angeles where the rents have been referred to as the second most expensive in the world. A national chain may calculate that they would be willing to lose money on the location because the placement of the store provides a much-needed prestige, and profits can be offset by other store locations.
Two underlying facts that are always glossed over; the middle class and even the upper middle class have been squeezed to the point that they have limited discretionary income to purchase goods from luxury retailers who mark up their products to offset the high rents. The second fact is that online purchases continue to accelerate as a percentage of the total which is currently at about 10% and increasing by the minute.
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