Occupancy cost plays an important role in analyzing commercial real estate (CRE) investments as it directly relates to your risk exposure as a landlord if one or more tenants decide to leave. If you want to own or invest in commercial property, particularly in office space or retail, learn what occupancy costs are, what's included in them, and how to conduct an occupancy cost analysis to determine the occupancy cost percentage.
What are occupancy costs?
Occupancy cost is the total expense a tenant incurs for leasing a particular building as stipulated in the lease. Occupancy cost is typically shown in a ratio or percentage that is calculated by taking the total occupancy costs for the tenant divided by the tenant's gross sales.
Each tenant should conduct a cost analysis and provide their annual occupancy cost to the landlord each year or when requested. The lower the total occupancy cost percentage, the lower the risk of the tenant leaving because they have a higher profit margin. The higher the occupancy cost ratio is, the higher the likelihood of a tenant leaving because of a lower profit margin.
What expenses are included in occupancy cost?
Occupancy costs will vary by lease type, as different leases (such as a gross lease vs. a net lease) place different financial responsibilities on the landlord or tenant. However, in commercial real estate, tenant occupancy costs can include:
- Base rent
- Local taxes
- Property taxes
- Property insurance or building insurance
- Common-area maintenance
- Ongoing property maintenance or upgrades
- Snow removal or lawn care
It's important to note that occupancy costs do not include the general operating expenses of the business with things such as payroll, marketing, service charges, or debt-service payments.
When is occupancy cost used?
Occupancy cost is a concept that is primarily used when analyzing and underwriting a commercial building, including office or retail space, but can be used when evaluating other CRE properties that have multiple tenants, like shopping centers. A tenant's occupancy cost helps the landlord or prospective buyer analyze the risk of the investment by identifying the likelihood of a tenant leaving because the overall cost to occupy the space is too high.
If you're evaluating a new investment opportunity, you can look at each tenant's occupancy costs to determine which tenant is more likely to leave their lease agreement, which has an opportunity for a rent increase because their occupancy costs are low, and which tenants are operating at par. It can also help you compare the performance of a building in relation to another to see which has a higher opportunity to charge additional rent or which has a higher risk of tenants (particularly an anchor tenant) leaving because their total cost is too high.
As a real estate investor, it's imperative that you understand how to review occupancy costs in order to compare one investment opportunity to other like-kind properties and evaluate your current portfolio's risk as a landlord. This, along with other metrics such as cap rate or tenant sales per square foot, can help you identify the best investment property for you in the given market and increase the performance of your current portfolio.