Understanding the Rent to Revenue/Sales Ratio Both as a Prospective Tenant and Landlord

According to Harvard University's Joint Center For Housing Studies 2020 study, rental rates in the United States have been growing for the past twenty-nine quarters. In such circumstances, it is critical for real estate participants to learn more about the subject of rent, and the Rent to Revenue Ratio (RRR) can assist them in doing so.

This ratio can be used to track how the cost of leasing commercial real estate affects the profitability and solvency of both the tenant and the landlord.

The rent-to-revenue ratio (RRR) is the percentage of gross annual revenue spent on rent by a tenant. In other words, this aids tenants in calculating the gross amount required to afford rent on a monthly/annual basis.

Understanding the Rent to Revenue Ratio

This ratio is sometimes called the Occupancy cost and is one of the most sought-after metrics used by the industry participants. It is calculated by dividing the annual rent by the forecasted annual revenue.

For example, if a business is anticipating its annual revenue to be $200,000 and is looking forward to renting an office space for $1,000 a month, then the RRR would be 6% (($1000*12)/$2,00,000).

By comparing the resulting RRR to industry standards, both the renter and the landlord can determine if the rent being charged is reasonable.

Although there is no ideal ratio for the entire commercial real estate sector, a few research firms, such as Bizminer, publish data on average industry financial ratios.

As per the report, depending on the industry type, RRR varies from 2-20%, and factors like location, site accessibility, utilities, size, and market conditions impact heavily.

A company renting space in Texas would pay significantly higher rent than a company renting space in a small town like Nevada.

The importance of the ratio also moves along with the type of business. A business with high margins would be more open to having a high RRR whereas, businesses operating on thin margins and cyclical industries would prefer maintaining a low ratio.

The rationale behind this ratio is that it aids a company's ability to make strategic decisions about the right level of investment in its workspace for various areas.

As per American Apartment Owners Association (AAOA), the industry standard for the percentage of renter's annual income that can be used to pay rent is 30. In other words, no more than 30% of a tenant's annual gross income should go for housing expenses.

There are, however, two problems with this rule. For starters, it does not account for inflation or rising rental rates. Rental costs frequently rise faster than societal income levels.

This rule also ignores personal financial objectives and market conditions.

Nonetheless, the Rent to Revenue Ratio acts as a key indicator for both tenants and landlords.

Rent to Revenue Ratio as a prospective Tenant

This ratio assists new tenants in narrowing down the properties they can pursue based on the rent they can afford. This simple step saves them time and increases the likelihood of their application being approved.

Every business, depending on operational and financial soundness and business opportunities, budgets the amount it plans on spending on real estate differently. Usually, new businesses have a budget of 15-25% of their revenue for rent and, the ratio goes down as the business (sales) prospers and rises.

This ratio provides tenants with a better understanding of the fund allocation. During different seasons, cycles, and boom and bust periods of the industry, the RRR enables them to plan the usage of their funds accordingly. They can better decide whether to invest the remaining reserve in enhancing sales or in using it to pay off other liabilities and costs if they keep track of how much of their revenue is spent on real estate.

For example, if a company's sales are down, a growing Rent to Revenue Ratio may alert management to the need to reduce the costs associated with maintaining the property.

Rent to Revenue Ratio as a prospective Landlord

Non-payment of rent is one of the key issues that independent landlords in the United States face. This is exacerbated by the high eviction expenses.

This ratio enables landlords to screen out ineligible applicants before getting into a much more comprehensive assessment process.

The large swings in RRR induced by shifting market conditions also alert landlords to the need to adjust rental prices in order to maintain or increase the property's occupancy level. Rent to Revenue Ratio also allows industries to maintain the standard rates and landlords to remain relevant in the industry by not overcharging or undercharging.

Because a renter may have additional financial commitments like mortgages, insurance, and so on, this ratio may not provide a clear picture of their financial situation. These responsibilities could eat up a large percentage of the tenant's income, leaving the bank account short of funds to pay the rent.

Landlords also run the risk of being provided with false financial information and documents by applicants.

Such possibilities make it necessary for landlords to take measures to ensure their protection.

Some of the measures that can be adopted

  • Having a co-signer on the lease: A co-signer, as a guarantor, can be requested who would be responsible for paying the dues in case the tenant fails to meet the financial obligations.
  • Recurring payment system: An automatic payment system can be set up to ensure payment on a monthly (or other agreed-upon) basis. The rent would be transferred directly from the tenant's bank account to the landlord's bank account using this mechanism.
  • Detailed background check: In addition to the current financial situation, landlords can gain a better understanding of the applicants' intent and character by looking at previous rental payment records.
  • Preliminary deposit or upfront fee: Another option to assure financial security is for landlords to request an advance payment from applicants, which will serve as a buffer in the event that the tenant goes bankrupt.

MyEListing can help

MyELisitng is empowering commercial real estate with tools for those looking to buy, sell or lease commercial real estate properties. MyEListing also provides access to free sales comps and free demographics for your property listing to help you be successful. Search for available commercial real estate in your area today!