Indexation assumes a tenant's ability to pay grows with prices. It grows with sales, after the service charge and rates have taken their share.
A retailer's rent capacity is a residual: its occupancy cost ceiling times sales, less service charge and rates. The sales growth it needs is therefore the growth in those other costs, plus the rent indexation, divided by the affordable occupancy cost. On an illustrative value operator paying rent at the limit of its capacity, with service charge rising 4 per cent a year, rates 3 and rent indexed at 2.5, sales must grow 3.08 per cent a year just to keep paying the rent, against 2.64 per cent for a jeweller in the same centre.
Worked in full in Retail Real Estate by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Rent reviews and indexation clauses assume that the tenant's ability to pay grows with prices. For most retailers it does not grow with prices; it grows with sales, and only after the costs that come before rent have taken their share. When those costs are a large part of the occupation bill, rent capacity behaves like geared equity.
| Input | Value operator | Jeweller |
|---|---|---|
| Area, m² | 1,000 | 100 |
| Sales ex VAT | 2,000,000 | 1,000,000 |
| Occupancy cost ceiling | 9% | 10% |
| Affordable occupancy cost | 180,000 | 100,000 |
| Service charge | 55,000 | 5,000 |
| Rates | 45,000 | 13,000 |
| Rent capacity, equal to rent today | 80,000 | 82,000 |
| Service charge and rates as share of affordable cost | 55.6% | 18.0% |
Cost assumptions, illustrative: service charge inflation 4.0 per cent a year, rates inflation 3.0 per cent, rent indexation 2.5 per cent. The value operator pays 80 per m² and the jeweller 820, but the point of the comparison is the shape of each tenant's costs, not the level of rent.
Rent capacity = ceiling × sales − service charge − rates
Growth to stand still = (Δservice charge + Δrates) ÷ (ceiling × sales)
Growth to keep pace with the rent = (Δservice charge + Δrates + Δrent) ÷ (ceiling × sales)
For the value operator in year one: service charge rises 2,200 and rates 1,350, so other costs rise 3,550; indexation adds 2,000 to the rent. Standing still needs 3,550 ÷ 180,000 = 1.97 per cent of sales growth. Keeping pace with the rent needs (3,550 + 2,000) ÷ 180,000 = 3.08 per cent. Over several years, solve the compound rate in Excel with Goal Seek on year-five capacity minus year-five rent.
The jeweller's other costs rise only 590 in the first year, 200 of service charge and 390 of rates, so it stands still with 0.59 per cent growth. Indexation adds 2,050 and takes it to 2.64 per cent. Solved over five compounding years the answers barely move: 3.09 per cent for the value operator and 2.64 for the jeweller.
| Year | Rent capacity | Indexed rent | Gap | Gap, % of rent |
|---|---|---|---|---|
| 0 | 80,000 | 80,000 | 0 | 0.0% |
| 1 | 80,050 | 82,000 | 1,950 | 2.4% |
| 2 | 80,044 | 84,050 | 4,006 | 4.8% |
| 3 | 79,977 | 86,151 | 6,174 | 7.2% |
| 4 | 79,848 | 88,305 | 8,457 | 9.6% |
| 5 | 79,651 | 90,513 | 10,861 | 12.0% |
Sales growth of 2.0 per cent, which would sound healthy in any trading update, leaves the value operator's rent capacity flat for five years while its rent rises by 10,513. By year five, 12.0 per cent of its rent is above what it can sustain. The jeweller, on the same 2.0 per cent growth, ends year five 3,521 short, 3.8 per cent of its rent.
| Annual sales growth | Value operator | Jeweller |
|---|---|---|
| 0% | 32.7% | 15.0% |
| 1% | 22.6% | 9.5% |
| 2% | 12.0% | 3.8% |
| 2.5%, equal to indexation | 6.6% | 0.8% |
| 3% | 1.0% | −2.2% |
The gearing explains the spread. The value operator's affordable occupancy cost is 2.25 times its rent capacity, so every 1 per cent change in sales moves its capacity by 2.25 per cent: a 5 per cent fall in sales cuts it by 11.2 per cent. The jeweller's gearing is 1.22, so the same fall costs it 6.1 per cent. Large, low-rent space with a heavy service charge is the most sensitive rent in a centre, which is the opposite of what its low rent per square metre suggests.
The common mistake is to assume that a tenant whose sales grow at the rate of indexation stays exactly as affordable. Its occupancy cost ratio does not stay put: the value operator's drifts from 9.00 to 9.26 per cent by year five, because the service charge, at 4.0 per cent, and the rates, at 3.0 per cent, are growing faster than the rent and the sales. The result is a 6.6 per cent gap that appears without any fall in trading. The correct test is not whether sales are growing, but whether they are growing faster than the hurdle computed above, trade by trade.
For the landlord this is a service charge question as much as a rent question. Every 1 per cent of service charge inflation removed saves the value operator 550 a year in the first year, which is capacity the landlord can then collect as rent. Controlling the charge is the cheapest way to protect the rent.
Rent capacity grows with sales minus the growth in everything else the tenant pays. Here the value operator needs 3.08 per cent a year to keep paying an indexed rent and the jeweller 2.64, and at 2.0 per cent the value unit is 12.0 per cent over-rented within five years. The free capacity and service charge workbook projects capacity by trade on the book's centre, and the occupancy cost ratio is the starting test it builds on.
Multiply sales excluding VAT by the occupancy cost ceiling for the trade, then deduct service charge and rates. An illustrative value operator with 2,000,000 of sales and a 9 per cent ceiling can afford 180,000 of occupancy cost; after 55,000 of service charge and 45,000 of rates, its rent capacity is 80,000.
Because rent capacity is a residual, it is geared to sales. When service charge and rates are a large share of occupancy cost, as with large value units, a small fall in sales removes a large share of capacity. In the illustrative case the value operator's gearing is 2.25, so a 5 per cent sales fall cuts its capacity by 11.2 per cent.
Not if service charge and rates rise faster than sales. In the illustrative case a value operator whose sales grow at the 2.5 per cent indexation rate still ends year five with rent 6.6 per cent above capacity, its occupancy cost ratio having drifted from 9.00 to 9.26 per cent.
This article is one calculation from Retail Real Estate. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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