What is Occupancy Cost Percentage?
The Occupancy Cost Percentage is the ratio between the total occupancy cost incurred by a tenant and the gross sales generated at the property.
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How to Calculate Occupancy Cost Percentage
The occupancy cost percentage, or “health ratio”, measures the total occupancy cost incurred by a tenant relative to the gross sales generated at the property, most often on an annual basis.
- Total Occupancy Cost → The total costs incurred by a tenant pursuant to a leasing agreement, such as the base rent, property taxes, and utilities.
- Gross Sales → The gross revenue generated by the tenant at the property.
The type of lease agreement is the primary determinant of occupancy costs, as the terms outlined in the lease agreement will state the party responsible for each cost (i.e. the lessee or the lessor).
In the commercial real estate (CRE) market, the total occupancy cost most often consists of the following:
- Base Rent
- Property Taxes
- Common Area Maintenance (CAM Charges)
- Percentage Rent
- Utilities
- Property Insurance
- Maintenance and Repair Costs
By comparing the total occupancy cost to the gross sales earned by a tenant, the percentage of a tenant’s revenue allocated toward meeting the lease obligations can be quantified.
The occupancy cost percentage is a method of ensuring the financial viability of a tenant from the perspective of the property owner.
While the contractual payment obligations of the tenant are stated in the lease agreement, it is still in the “best interests” of the property owner to make sure the financial health of the tenant is in good standing.
Otherwise, the tenant is more likely to vacate the space (non-renewal), or in the worst case scenario, be at risk of defaulting and becoming insolvent.
What is a Good Occupancy Cost Ratio?
Generally speaking, the lower the occupancy cost percentage, the greater the likelihood that the tenant will remain at the current property over the long term.
Conversely, the higher the occupancy cost percentage, the more likely the tenant will vacate – since remaining at the current property is not economically feasible for them over the long run.
If the occupancy cost percentage is outsized relative to the relevant industry benchmark (with a material impact on profit margins), the tenant is prone to vacate the space or property, as the current cost structure is thus not sustainable.
Hence, in such a case, a property owner (or landlord) should consider offering a reduction in the base rent or reimbursements to incentivize the tenant to remain.
How to Interpret Occupancy Cost Ratio in Retail Sector
Of the sectors in commercial real estate, the retail segment tends to be the most sensitive to the occupancy cost ratio.
The primary reason for the importance of tracking the occupancy cost percentage in the retail sector is because tenants can move around much more easily relative to other sectors.
There are exceptions, of course, but as an illustrative example – consider the mobility of a coffee shop compared to a niche manufacturer occupying an industrial warehouse.
The sub-segments of the retail sector with the lowest occupancy cost percentages include pharmacies and cosmetic supply stores, whereas those with the highest percentages include movie theaters and fitness centers.
The retail sector suffered steep losses amid the COVID-19 pandemic. However, the retail sector, aside from shopping centers, has now normalized, with a positive outlook heading into 2024 – despite the shift in consumer spending from “brick-and-mortar” to eCommerce.
The outlook for the retail sector is rather positive, attributable to the emerging trend of the omnichannel retail strategy – such as Starbucks (SBUX) integrating its Starbucks Rewards mobile app for in-store pick-ups.
Starbucks Rewards – Omnichannel Example (Source: Starbucks)
Occupancy Cost Percentage Formula
The formula to calculate the occupancy cost percentage is the ratio between the total occupancy cost and gross sales at the given property, expressed as a percentage.
Since the occupancy cost ratio is expressed as a percentage, the output must then be multiplied by 100.
The percentage can be compared to historical data as well as industry comparables to benchmark performance.
