Occupancy Cost Ratios in Rental Valuations

Should valuers use occupancy cost ratios in market rental valuations of commercial properties?

The use of occupancy cost ratios in the valuation of market rents for commercial and retail properties has been a topic of debate among real estate valuation professionals for many years. These ratios, which compare the rent and outgoings of a property to the gross sales of a particular tenant, are often used as a benchmark in the leasing process, particularly in shopping centres. However, their use in determining market rents remains controversial, particularly in retail standalone or strip locations. One of the main arguments against the use of occupancy cost ratios in rental valuations, is that they consider the goodwill and fitout of the tenant.

Valuers are tasked with determining the market rent of a property assuming vacant possession, which means ignoring any value associated with the tenant’s existing business, goodwill, and fitout. However, most market rent reviews are triggered by options, where a sitting tenant wishes to extend their lease and will have an established business and fitout. On the other hand, both landlords and tenants often use occupancy cost ratios in the leasing process to determine the affordability of a property for a particular use. This shows that these benchmarks are considered by the market and cannot be completely ignored in the valuation process. In shopping centres, the use of occupancy cost ratios to set rents for new leases and renewals is routine, as this information is readily available.

Another issue with occupancy cost ratios is that they do not consider the location and market conditions of a property. A high occupancy cost ratio may be acceptable in a prime location with high foot traffic and strong demand, but the same ratio in a less desirable location may be considered too high. This highlights the importance of considering other factors in addition to occupancy cost ratios when determining market rents.

Despite these criticisms, occupancy cost ratios can still be a useful tool in the valuation and leasing process. They provide a benchmark for both landlords and tenants to assess the affordability of a property for a particular use and can be a starting point for negotiations. In the past, obtaining this information was a challenge as there were limited sources of business benchmarking available. However, with the rise of big data, the Australian Taxation Office (ATO)  now provides a comprehensive range of small business benchmarks, including rent expenses/turnover benchmarks. The ATO has access to millions of business records, which they use to ensure tax compliance. This means that the ratios provided in their benchmarks are reliable and can be used as a guide for landlords and property owners. However, it is important to note that these benchmarks are usually 1-2 years out of date, so they should be used as a general reference rather than an exact measure.

Furthermore, they should not be the primary determinant of market rents and should be used in conjunction with other valuation methods and market data. In conclusion, the use of occupancy cost ratios in the valuation of market rents for commercial properties remains a contentious issue. While they can provide a useful benchmark, they should not be relied upon as the sole method of determining market rents. Valuers must consider other factors such as location, market conditions, and the individual characteristics of each premises to arrive at a market rent.

Conclusions

Specialised rental valuations of retail, childcare, medical and aged care are complex and muti faceted.  IPS Consultants are an independent consultancy with more than 25 years’ experience in this field and regularly provide complex analysis in these areas.