Understanding the Rent-to-Sales Ratio, Both as a Prospective Tenant and Landlord
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This article was updated on 7/13/2023.
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's 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.
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.
This metric, also referred to as the rent-to-sales 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.
Understanding the Rent to Sales Ratio
This ratio is sometimes called the "occupancy cost" and is one of the most sought-after metrics used by industry participants. It's calculated by dividing annual rent by the forecasted annual revenue.
How Do You Calculate the Rent to Sales Ratio?
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 rent-to-sales ratio would be 6% (($1000*12)/$200,000) = 0.06).
By comparing this resulting rent-to-sales ratio to industry standards, both the renter and the landlord can determine if the rent being charged is reasonable.
What's the Best Rent to Sales Ratio?
Although there's no ideal rent-to-sales ratio for the entire commercial real estate sector, a few research firms, such as Bizminer, publish data on average industry financial ratios.
According to Bizminer, depending on the industry type, the ideal rent-to-sales ratio varies from 2% to 20%, and factors like location, site accessibility, utilities, size, and market conditions impact it heavily.
A company renting space in Texas, for instance, would pay significantly higher rent than a company renting space in a small town like Nevada.
The importance of this ratio also moves along with the type of business: A business with high margins would be more open to having a higher ratio whereas businesses operating on thin margins and cyclical industries would prefer maintaining a low ratio.
Why Use the Rent-to-Sales Ratio in the First Place?
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 the 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 toward 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-sales ratio acts as a key indicator for both tenants and landlords.
Understanding the Rent-to-Sales 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 anywhere between 15% and 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 necessary fund allocation. During different seasons, cycles, and boom and bust periods of the industry, the rent-to-sales ratio 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-sales ratio may alert management to the need to reduce the costs associated with maintaining the property.
The Rent-to-Sales Ratio as a Prospective Landlord
Non-payment of rent is one of the key issues that independent landlords in the United States face, exacerbated by high eviction expenses.
This ratio enables landlords to weed out ineligible applicants before getting into a much more comprehensive assessment process.
Large swings in this ratio 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. This 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 needed 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.
Protection Measures That Landlords Can Utilize
Here's a list of some of the measures that landlords can utilize to protect their bottom lines from delinquent rent payments and irresponsible tenants.
#1 – Having a Co-Signer on the Lease
A co-signer, as a guarantor, would be responsible for paying dues in case the tenant fails to meet their financial obligations.
#2 – A Recurring Payment System
An automatic payment system can be set up to ensure payment on a monthly (or another agreed-upon) basis. The rent would be transferred directly from the tenant's bank account to the landlord's bank account in this way.
#3 – Detailed Background Checks
In addition to the current financial situation, landlords can gain a better understanding of applicants' intent and character by looking at previous rental payment records.
#4 – Preliminary Deposit Fees
Another option landlords can use to ensure financial security is to request an advanced payment from applicants, which will serve as a buffer in the event that the tenant goes bankrupt.
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