When underwriting a retail investment, rollover risk is an incredibly important consideration. You, as a prospective debt or equity investor in the property, need to understand how secure the cash flows you’re buying are; or in other words, how likely each tenant is to renew their lease at the end of their lease term.
This is especially true in situations where the risk is binary. Take a grocery-anchored retail center as an example. At the end of the grocer’s term it will either renew or vacate. If the grocer vacates the center dies. If it renews the center survives. And so today I’d like to discuss two separate but related metrics that provide hints as to whether a given tenant will renew at the end of their lease term or not: tenant sales per square foot and occupancy cost percentage.
What is Tenant Sales Per Square Foot?
Tenant sales per square foot (Tenant Sales PSF) is the total revenue a tenant earned in a year on a per square foot basis at a given location. So for instance, a jewelry store occupies 10,000 square feet at your shopping center and in 2016 the store sold $3,500,000 worth of product. That jewelry store did $350 per square foot in sales in 2016 at your shopping center.
Tenant’s Annual Gross Sales at the Location
Square Feet Occupied by Tenant
Tenant Sales PSF
It is generally a requirement of the lease that the tenant report, at the end of each year, their gross sales at that location for the year. This is necessary because many retail leases include percentage rent clauses, which are based on total sales, but also so that the landlord has a feel for how the tenant is doing financially.
What is Occupancy Cost Percentage?
Occupancy cost percentage is the percentage of a tenant’s total revenue that goes towards covering the costs of occupying their space. The tenant’s annual occupancy cost is the sum of all costs associated with occupying their space such as base rent, common area maintenance reimbursements, real estate tax reimbursements, and percentage rent.
Tenant’s Annual Occupancy Cost at the Location
Tenant Annual Gross Sales at the Location
Occupancy cost is a great metric when it comes time to renegotiate the lease. If the tenant’s occupancy cost percentage is too high, they might vacate their space or require a reduction in their base rent or reimbursements in order to stay. Likewise, if the tenant’s occupancy cost is low, the landlord might have room to raise rents or demand higher reimbursements from the tenant.
What Constitutes a High Occupancy Cost Percentage or Weak Sales PSF?
Gathering the data and calculating the metrics are only a small part of the process. The real value comes in properly analyzing the outputs so as to make wise business decisions. So the question is, how do I know if the tenants’ sales PSF are good, bad, or typical? How do I know if the tenants’ occupancy cost percentage is too high, too low, or just right? How much should I care about tenant sales PSF and occupancy cost percentage for a given tenant? Well the short answer is, it depends.
It depends on the type of retail (neighborhood, regional, shopping mall, power center, etc), the tenant and how this store compares to their other stores, the location, the prospects for growth, and how important the tenant is to the center’s viability. So for instance, a small, family-owned pizza place located in a grocery-anchored retail center will have different sensitivities to the ratio of occupancy cost to annual sales than a high-street retail tenant on Newberry street. Or as a landlord, I care more about the sales PSF of my anchor tenant than I do with the small in-line tenant next door, regardless of the property.
In terms of how to ascertain what is a good sales per square foot figure or a poor occupancy cost percentage, there are a few sources where you can turn. Green Street Reports (see example) provide average tenant sales PSF for the various markets they track, Korpacz Realty Advisors puts out an annual Regional Mall Classification Methodology Report with tenant sales PSF by mall type, publicly traded REITS will often report sales and occupancy cost data in their investor presentations (e.g. GGP) and brokers can sometimes provide you with tenant sales and occupancy cost information at comparable centers. Even so, this data is not as readily available as others (e.g. rent rates, reimbursement percentages, etc) and so, like with many aspects of real estate underwriting, the more deals you look at the better your analysis becomes.
Video Tutorial on Calculating Sales PSF and Occupancy Cost Percentage
Download the Excel Workbook for Calculating Tenant Sales PSF and Occupancy Cost Percentage
- Basic Excel workbook showing the method I use to calculate tenant sales PSF and occupancy cost ratio
- Use with unlimited number of tenants
- Built in one tab for easy export to your Retail Excel Model