What are Occupancy Costs in Commercial Real Estate?

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Key Takeaways

  • Occupancy costs in commercial real estate are the total costs that are incurred by a tenant when leasing space in a commercial property.
  • Occupancy costs can vary by tenant and lease, but they usually include some combination of: base rent, property taxes, insurance, utilities, common area maintenance, and tenant improvements.
  • The process of calculating occupancy costs is simple – it is the sum of all expenses that a tenant incurs as part of their occupancy.  Deciding which costs to include in this calculation can be a bit trickier.  The easiest way to figure it out is to go by the terms of the lease.
  • From an analysis standpoint it is important for real estate investors to look at occupancy costs as a proxy for a tenant’s willingness to renew their lease.  If costs are high, they may want some sort of concession in a renewal negotiation.  If they are low, it may be a sign that there is room for rent increases.
  • For individual investors looking to deploy capital into commercial real estate assets, it can be helpful to partner with a private equity firm.  Doing so means that the private equity firm can worry about all of the hard to work needed to calculate occupancy costs and negotiate leases.

When a tenant leases a space in a commercial property, their cost of doing so is not limited to their monthly rent.  Often, there are ancillary costs that are outlined in the terms of the commercial real estate lease that can increase the total occupancy costs.

In this article, we are going to discuss total occupancy costs for tenants who lease commercial space.  We will describe what they are, how they are calculated, why they matter, and how they contribute to the profitability of a commercial real estate investment.  By the end, readers will be able to calculate occupancy costs on their own and use them as a data point in their pre-investment due diligence and lease negotiation processes.

At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers.  Before purchasing a property or re-negotiating a lease, we always look at a tenant’s occupancy costs as an important input in this process.  If you are an accredited investor and would like to learn more about our current investment opportunities, click here.

What Are Occupancy Costs?

Occupancy costs are the total expenses incurred by a tenant when leasing space in a commercial property.

What Occupancy Costs Include

Although they can be unique for each tenant, occupancy costs usually include some combination of the following:

  • Base Rent:  The amount of the tenant’s rent, usually expressed on a per square foot basis, that is charged for the privilege of occupying the space.
  • Property Taxes:  Property taxes are fees charged by the city/municipality for the use of their services like trash and water.  Based on the specifics of their lease agreement, the tenant may be required to pay some pro-rata share of the taxes associated with the property.  For example, if they occupy 1,000 SF in a 10,000 SF building, they may be required to pay 10% of the taxes.
  • Property Insurance:  Commercial real estate owners often carry multiple types of insurance to protect themselves against financial loss in the event of an unforeseen event.  Again, the tenant may be required to pay their pro-rata share of the total cost of the insurance that covers the property.
  • Utilities:  Depending on the property, a tenant may be required to pay all or some of the utilities cost associated with their occupancy of the space.  If the property is sub-metered, the tenant may pay all of their own expenses.  If it isn’t, they may be required to pay their pro-rata share.
  • Common Area Maintenance:  Some property types – including retail space and office space – have a variety of common areas that are used by all tenants.  Examples include parking lots, elevators, lobbies, hallways, and gyms.  There is a cost to maintaining these spaces and each tenant usually has to pay their share.
  • Upgrade/Tenant Improvements:  If a tenant wishes to customize or improve their commercial real estate space before moving in, they may have to pay for some of all of the cost associated with doing so.  In some cases, a property owner may offer a “TI Allowance” to the tenant as part of their commercial lease terms to help offset this cost. 

In a “gross lease” arrangement, the occupancy costs above are usually included as part of a single monthly rental rate.  In a “net lease” arrangement, these operating expenses may be “a la carte” depending on the type of net lease signed.  For example, in a triple net lease, the tenant pays base rent plus their share of property taxes, insurance, and maintenance.

How to Calculate Occupancy Costs

The math of calculating occupancy costs is simple.  It is the sum of all of the costs that are incurred by the tenant as part of their occupancy.

Figuring out which costs to include as part of the calculation is a little bit trickier.  Fortunately, they are usually outlined in the details of the lease.  For this reason, it is important for tenants and investors alike to read the lease to pick out which costs are included in the total, annual occupancy cost calculation.

As a general rule, it is easier to calculate occupancy costs for gross leases because everything is rolled into the single monthly rental rate.  It is harder for net leases because tenants and investors have to take the base rent and add the a la carte costs to it to come up with the total cost.

When Investors Use Occupancy Cost Calculations

As a metric, occupancy costs are used at two points in a typical commercial real estate (CRE) transaction.  The first point is as part of the pre-purchase underwriting process.  The second point is when a lease comes up for renewal.  While occupancy costs can be calculated for all tenants, they are particularly important for the anchor tenant.  To illustrate this point, an example is helpful.

Suppose that a commercial real estate investor is considering the purchase of a grocery store anchored retail center.  At the time of purchase, the grocery store anchor has 3 years left on their lease term and the success of the investment depends on the anchor tenant renewing their lease upon expiration.  To help weigh the odds of renewal, the underwriter/analyst will calculate the occupancy cost and a related metric known at the occupancy cost percentage.

If a tenant’s occupancy costs are low relative to the market, it may signal to the investor/property owner that there is a chance for rent increases.  At the other end of the spectrum, high occupancy costs relative to the market mean that a tenant may likely ask for lower rent to bring their overall cost in line with the market.  Otherwise, they may not renew their lease.

Occupancy cost percentage is a metric that measures a tenant’s occupancy cost relative to their gross sales.  Although the metric is a slightly different way of measuring occupancy costs, the implication is the same.  If, as a percentage of sales, occupancy costs are too high, the tenant may be less likely to renew their lease and/or more likely to ask for some sort of concession to bring their total occupancy costs down.

The point is this.  The odds of the anchor tenant’s lease renewal has a major impact on a property’s market value.  If the occupancy costs are high, the value may be lower to reflect the risk of a non-renewal.  If the occupancy costs are low, the offer may be a bit higher because the investor may have more confidence that an anchor tenant will renew their lease. 

Occupancy Costs & Investing through Private Equity Real Estate

Calculating occupancy costs is an important part of the process needed to safely and effectively acquire and manage a commercial real estate asset.  Doing it correctly requires experience, expertise, and time, all things that individual investors may not have.

For this reason, it can be helpful for individuals to partner with a private equity firm when making a commercial real estate investment.  Doing so allows them to leverage all of the resources, experience, expertise, and relationships of the private equity firm to benefit their own investment.  In many cases, this can have a positive impact on the profit margins of the investment, which allows an individual to grow their real estate portfolio in a cost-effective manner.

Interested In Learning More?

First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.

If you are an Accredited Real Estate Investor  and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.

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