Like most things in life, commercial real estate may seem complicated, but the best way to understand something complicated is to break it down. Each investment has its own set of unique characteristics, and if understood and read appropriately, they begin to outline a picture. So, to better determine the value of an investment, investors should equip themselves with the knowledge to understand the role each fundamental factor plays. The more each element can be recognized, the clearer the picture will become.

 

What Is a Rent-To-Sales Ratio?

Mathematically speaking, a rent-to-sales ratio measures the relationship between a business’ gross annual sales and their total annual rent paid. For those who don’t like math, the rent-to-sales ratio is a rating, usually expressed as a percentage, that determines how impactful the cost of leasing a location will be on the business’ bottom line. The rating is found by simply dividing the business’ total annual rent by their gross annual sales. In commercial real estate, the rent-to-sales ratio is one of the fundamental indicators that investors look at to determine the current performance and outlook of their investment or potential acquisition.

 

How it Affects Tenants

For a tenant, the rent-to-sales ratio helps them decide if a location makes economic sense for their business. The rent-to-sales ratio can vary depending on the type of business or asset class. In retail, tenants aim for a rate below ten percent, ideally operating between a six to eight percent rentto-sales. Anything in this range is typically considered healthy, where the tenant’s sales performance justifies the rent that they are paying the landlord.

 

Affect on Property Value

Good investors understand that the overall security of their investment directly impacts its value. Most leases do not allow landlords to see store sales, but when they do, those figures can reveal valuable insights into tenant health and rent sustainability. However, this transparency can be a double-edged sword— strong sales performance supports asset stability and value, while weak sales can signal risk and potential turnover.

When it comes to security, the higher the rent, the less profit a business typically takes home when compared to a property with lower rent and equivalent sales. With this in mind, it makes sense that a business with a lower rent-to-sales ratio tends to be more profitable and is better positioned for stability through market fluctuations. This increases the odds of the tenant staying at a location longterm.

Consequently, a business with a higher rent-to-sales ratio is typically less profitable and carries more significant risk of losing money during economic downfalls. Thus, a high ratio increases the likelihood of the tenant asking for rent reductions or potentially vacating the site during the base term or at the end of their lease.

Properties with low rent-to-sales ratios are perceived to have higher security and therefore they hold more inherent value. On the other hand, properties with a high rent-to-sales ratio have lower security and could, therefore, hold less value.

 

How Should Investors and Landloards Respond?

High Rent-To-Sales Ratio

Rent reductions and vacancies can be detrimental to the value of real estate. If rents become too high and the location no longer makes financial sense for a tenant, they will most likely ask for a rent reduction or threaten to vacate at the end of lease. Ultimately, leaving the landlord with little leverage.

In cases like this, the landlord becomes wedged between a rock and a hard place because the tenant now holds the upper hand in lease negotiations. Landlords should try to avoid this by carefully monitoring store sales and checking in with their tenants. If a property’s rent-to-sales ratio is moving in an upward trajectory, it may make sense to consider selling the property before it negatively impacts the value of their investment. In situations like this, investors can take advantage of a 1031 exchange to upgrade their investment to an asset with stabilized rent and more security.

If an investor is looking to purchase a property, unless they have a solid plan to re-tenant with a more suitable business or find a new use for the real estate, then they should steer clear of properties with a high rent-to-sales ratio unless accounted for in the purchase price.

 

Low Rent-To-Sales Ratio

A low rent-to-sales ratio usually indicates that: A tenant can generate a healthy profit at the subject location, rents can be increased without causing major distress, or the investment holds strong potential for long-term appreciation a business’ success can be extremely volatile. Even when sales are high landlords should remain alert and cautious. Times change, fads pass, and hugely successful businesses are never immune to market f luctuations. Some leases include large rent increases throughout the base term. These increases can be annual or structured every few years based on a number of different factors. Common rent increases include: 1 to 2 percent annual increases or 5, 7.5, 10, or 12 percent increases every 5 years.

Not surprisingly, it is common to see a property’s rent-to-sales ratio increase over time with large rent increases built into the lease. The tenant’s sales need to increase in parallel with rent increases to maintain a healthy rent-to-sales ratio, which ultimately affects the value of an asset. This is why investors target properties with a history of consistently increasing annual store sales. If sales are not reported per the lease, it is still possible to look out for red flags in the tenant’s business.

If a landlord has owned a property for five to ten years and it still has a strong rent-to-sales ratio they may want to consider selling their asset and taking advantage of this situation before the tenant’s store sales plateau. As the base term of a lease burns off, net lease properties tend to decrease in value. So, after five to ten years of holding an investment, it can make sense to sell before the rent gets too high and the sales do not follow. Properties with 10 or more years of base term tend to sell for higher values than properties with less than 10 years on the base term. Plus, the difference in cap rates of deals with 10 to 20 years on the lease does not fluctuare as aggressively as deals with one to nine years on the lease. With a few healthy rent increases, owners can often sell for more than their initial purchase price.

For investors looking to purchase a new property, it is essential to consider all factors that affect the value of the real estate. A low rent-to-sale ratio is a good indication that the investment will hold its value longterm. After purchasing, make sure to monitor your tenant’s sales and be prepared to sell if the rent gets too high or the sales do not increase over time.