How sales impact market rent, contract rent, and a shopping center’s bottom line
Oct 7, 2013
Eugene R. Szkilnyk
CCIM
Director, Integra Realty Resources - DetroitAll rents are not created equal — especially in a shopping center during a recession. Imagine, for example, a shopping center that contains both a Starbucks and a local coffee shop. The two stores sit next to each other and occupy the same amount of floor space, but the Starbucks draws in significantly more business. While outwardly similar, that one factor — sales — is why the Starbucks might pay $25 per square foot while the local shop pays only $17 per square foot.
It’s not uncommon for stores within the same center to pay different rents, a factor that every investor needs to keep an eye on when acquiring a shopping center. This one variable can significantly raise cap rates for investors who aren’t tuned in to what each tenant is paying. Let’s look at the factors at play in determining rent rates and their impact on the value of a shopping center.
The role of tenant sales in contract rent
Smart landlords don’t assign a flat rent rate to every tenant in their shopping centers. Instead, landlords determine rent based on a tenant’s potential or expected sales numbers. Known as a percentage lease, this agreement sets a base rent on square feet, then adds a percentage of total tenant sales. That means that success comes with a price, so in the case of our coffee shops, Starbucks pays more for rent because it sells more than the local shop.
This system also means that contract rent fluctuates in step with the economy. If the economy blooms, then tenants sell more, and contract rent increases, but if the economy dips, then tenants sell less, and contract rent drops.
Other factors affecting rent
In addition to total sales, tenants and landlords take visibility into account when calculating rent. Visibility equates to the amount of vehicle and pedestrian traffic a store receives within a shopping center. Landlords can charge higher rent to stores with greater visibility since visibility correlates with total sales.
Hand in hand with visibility is the store’s location within the shopping center, yet another factor in rents. Tenants located at the ends of the shopping center (known as end caps) pay higher rent, since these positions place stores closer to streets, providing them greater visibility and increased sales. Stores relegated to elbow positions receive lower visibility and spend less on rent.
What percentage rent means for investors
Because rents can vary from store to store depending on tenant sales, location, and visibility, future investors face potential danger when purchasing these properties. Often, investors hire local brokers and appraisers to calculate fair prices for potential shopping center acquisitions. A broker or appraiser without adequate shopping center appraisal knowledge might not understand the nuances associated with evaluating these pieces of land.
For example, a developer might construct a shopping center and pre-lease a single unit for $25 per square foot, in this case, we’ll say to Starbucks. When the developer looks to sell the property, he typically turns to an appraiser or broker to value the project. Often, appraisers will assume the pre-lease rate as a reliable indicator of market rent and appraise the unleased space at the same rate.
Yet within a few years, the existing tenants, other than Starbucks, might realize that their projected store sales volume cannot justify the rent. The tenants then ask the property owner to modify the lease to align the contract rent with what each tenant, based on their business model, can afford to pay.
The investor, because of his reliance on the Starbucks lease, believed the price paid was economically sound based on a market rent of $25 per square foot, failing to recognize that each retail tenant has a unique profit margin, and $25 per square foot represented the top of the range of rents paid per square foot.
Based on that rent level — 10% vacancy, 3% management, and a 10% capitalization rate — the investor might have paid $2.2 million for the property. But if the prevailing market rent for the retail space is actually $17 per square foot, assuming the same vacancy, management, and cap rate, the adjusted value would be $1.55 million, meaning the buyer overpaid by $650,000 and took a substantial hit to his return on investment.
In this instance, the appraiser calculated the overall market rent of a shopping center based on one recent lease for a business with high sales potential, using that rate as the sole indicator of market rent for the unleased spaces. In reality, there would be a mix of tenants with varying abilities to pay certain levels of rent. Appraisers assuming that all tenants have the same high sales per square foot as the Starbucks led to an overestimation of attainable rent for the rest of the center. Without insight into true market rent, appraisers might fall victim to overestimation and leave investors at the wrong end of a bad deal.
The moral of the story: due diligence. Not all brokers and appraisers are created equal. As an investor, before entering into a multimillion dollar shopping center acquisition, make sure to research brokers and appraisers who specialize in this type of real estate and are most familiar with the local market. Without experience on your side or insight into how rents are determined, buyer beware.
