Deciding to lease space for your business is both a considerable financial investment as well as an investment into your employees and your customers. Whether you are renting a large office space to house your team of employees or a small retail space to grow your business sales, there are an array of benefits to leasing commercial space.
As you evaluate rental options, a preliminary point of consideration will be the financial requirement.
Determining the ideal rent percentage of income is key, and it’s based on multiple factors. In many cases, it is not uncommon for some businesses to have leases that dominate a large percentage of monthly budgets. The space itself costs money, but the calculation you perform will help you determine how much money it will help you bring in for your business.
For example: An event venue has an annual net revenue of $400,000 which at first glance seems like a strong revenue stream. However, their monthly rent in the center of downtown costs $20,000, totaling $240,000 annually. In this scenario, the rent to income ratio is quite low, which means this space could potentially, overtime, lower the business’s profitability or completely undermine the financial health of the business.
This example illustrates the importance of careful planning when leasing office or retail space.
Knowing your budget, finding the right size of commercial space, and exploring options like class B buildings, managed office space, or small retail spaces for rent can move your company toward cost-effectiveness.
In calculating your rent to percentage of income, the natural question is this: how much of your income should go to rent? In this piece, we will share the best ways to calculate the ideal rent to income ratio for your business.
Covered in this article:
- Rent Percentage of Income: What Percentage of Sales Should Go to Rent?
- Calculating Rent Based on a Percentage of Sales
- How to Compute Rent Percentage of Income
- Occupancy Cost Percentage by Industry
- Analyzing Your Rent Percentage of Income
- Expert Commercial Lease Analysis
Calculating Rent Based on a Percentage of Sales
There is no one-size-fits-all rule for how much a business can spend on rent for a commercial space. A building provides a home base for a business—whether a place for their employees to put in productive hours or a place for customers to make a purchase. Companies across different industries will value the cost of a particular location differently and have varying office and retail space needs.
Rent to income ratio is one way many businesses determine if they can afford a particular commercial lease space. The formula measures a renter’s ability to pay rent and is calculated by dividing gross annual rent by gross annual income.
Gross income is the amount a company makes before accounting for any expenses. It is the company’s income before any taxes or deductions are taken out.
In contrast, net income is income after taxes and deductions. Any business expense, including rent, are paid out of a business’s net income.
Calculating this ratio provides a business rent to income ratio or occupancy cost percentage.
In its simplest form, the higher your income, the more your business can afford in rent.
With these metrics, decision-makers can decide on revenue spending for particular commercial spaces. In many cases, it’s significant to consider how a prime location with a higher rent tag may generate higher income. Business owners would do well to consider the relation of rent cost for an ideal location, compared against income potential from that location.
Today, business leaders understand the importance of utilizing the rent to income ratio and occupancy cost metrics as they budget and scout locations in the commercial leasing process.
Depending on what you’re selling, the standard rent to income ratio can range anywhere from less than 1 percent all the way up to more than 13 percent, with most industries paying below 10 percent. In the next section of this guide, we’ll discuss how to compute your exact rent percentage of income.
How to Compute Rent Percentage of Income
Calculating what percentage of your sales go toward your rental costs involves a straightforward equation. First, determine the annual cost of your rent. Then, divide your annual rent by your gross annual income. Remember, your gross annual income is your income before any taxes or deductions are taken out.
If your annual rent is $122,255, for example, and your gross annual income is $1.98 million, you would divide $122,255 by $1.98 million.
Your total would come to 6.17 percent.
That means for every $1 your company earns, 6 cents goes toward the rent.
When you are considering a new lease, you can use the same concept to target the maximum amount of rent you can realistically pay to still reach your target profits. You can also approach the decision from a different perspective: start with the rental cost for a potential location and then determine the needed net income to meet the target percentage of sales.
Occupancy Cost Percentage by Industry
Occupancy costs are the total expenses incurred by a tenant when leasing space in a commercial property. It is the sum of all the tenants’ costs as part of their occupancy.
Consisting of annual rents divided by annual sales, occupancy costs provide helpful metrics in determining how much a tenant can afford in rent.
Calculating occupancy costs are helpful for both tenant and landlord.
For example, in considering a restaurant tenant versus a dress shop, a landlord would analyze how much each tenant’s annual rent would represent out of their total annual sales. While the restaurant may initially seem like a stronger tenant, further analysis would show that rent is only 11% of the dress shop’s annual rent versus 15% of the restaurant’s. With these helpful metrics in hand, landlords can measure a tenant’s long-term ability to pay rent and make a decision that supports the occupancy outlook for the property.
The type of lease also affects occupancy costs. For example, if you enter into a triple net lease, it’s essential to consider additional expenses associated with this lease type. In a triple net lease, the tenant or lessee is also responsible for the full expenses of the property in addition to the base rent cost. These expenses include real estate taxes, building insurance, maintenance, and utilities.
Below is the occupancy cost percentage for different industries as of June 2021.
Rolling 12-month average
(July 2020-Jun 2021)
Source: NewMark Merrill Companies
Analyzing Your Rent Percentage of Income
Analyzing your rent percentage of income is an astute business practice to complete as part of the commercial leasing process.
Calculating this metric determines whether your rent to revenue ratio is ideal for your business and whether it will support long-term growth and success for your company.
Ask these questions when considering whether your rent percentage of income is balanced:
1. Are you paying too much for your commercial space? (i.e., Is your rent consistent with the industry average per square foot cost?)
2. Is your company falling behind the competition and industry-standard rental ratio targets? If so, this may mean your business operates in a potentially outdated space that lacks industry-standard amenities.
Regarding rent percentage of income, there are two common scenarios a business may face. Knowing how to proceed when your business faces these situations is one of the many factors that will determine long-term business success.
Low Occupancy Costs
Businesses experiencing low occupancy costs are better suited to weather economic volatility and rising staffing and supplier costs. However, a low sales-to-rent ratio does not always point to a business paying a low industry rent to its landlord. Sometimes, it just means a strong business and an over-priced commercial lease. On the other hand, prime retail or downtown office space often carries a higher price tag than a strip mall or office building in the suburbs. Increased foot traffic and local amenities can often compensate for higher rent costs as well. The key is for tenants to do their due diligence before entering into a commercial lease to ensure they are paying fair market rent.
High Occupancy Costs
Businesses experiencing high occupancy costs need to re-evaluate their location, space use, and potentially negotiate a rent reduction from their landlord. A landlord with low-demand commercial space will be more likely to agree to a rent decrease if they can’t quickly release the space to another tenant.
Rent percentage of income is just one of many metrics in determining the value of an office or retail space to your business. A professional commercial leasing agent can also guide you in selecting the right commercial space for your business.
Expert Commercial Lease Analysis
When it comes to making high-stakes decisions for your business, financial metrics are a helpful tool in determining the best course of action to support long-term business success. Rent to income ratio and occupancy costs are just two of the many valuable metrics to consider in the commercial leasing process.
Factoring in the rent percentage of income allows decision-makers to select office space or retail properties that provide the greatest potential for income and business effectiveness. With metrics in hand, businesses can make astute investments for both the company and their employees.