In this 7 minute read, learn:
- Why the average cost of rent for a small business is not the most useful statistic
- The best way to approach your landlord about your rent to income ratio
- What percentage of your business should be spent on rent
- The “unit cost” method of determining what you should pay for rent
If you’re a current business owner wondering if your rent is too high, this article is for you. If you’re considering renting business or office space for the first time, or perhaps the owner of a growing business wanting to move to a larger commercial space, please refer our article: How much does it cost to rent space for a small business?
It’s time to address that gut feeling that you might be paying too much in rent. In this article, we’ll explain why questions like “what’s the average cost of rent for a small business” aren’t as useful as using a ‘unit economics’ approach.
We’ll also show you how to use unit economics calculations to determine if you’re paying too much for your rent, and discuss the best ways to negotiate a lower rate.
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The “average cost of rent for a small business” and the wrong way to negotiate your lease
When you’re trying to determine how much your rent should be, it’s tempting to try to research the average rent for a small business.
Much like when a renter searches through average rent reports for a specific city to find their city’s average rent, this is the wrong approach and doesn’t really tell you anything useful (we’ll explain why below).
Furthermore If you “just know” you are paying too much in rent, and you try to renegotiate, the first thing your landlord will say is, “Show me the proof! Show me the numbers.”
Responding with, “But… I just know you’re charging too much!” is a shortcut to stalemate and could even jeopardize your relationship.
If you want to make a strong case and generate black-and-white numbers, you need to know the “unit economics” of your small business.
Alan Wille, CEO of Klipfolio, a business performance metrics company, defines unit economics as looking at the direct revenues and costs associated with the most basic element of a company’s business model. In other words, unit economics breaks down everything about your business into individual pieces.
Unit economics is a more accurate view than “how much is rent for a business”
“Done properly, a unit economics analysis will highlight opportunities, expose gaps, and direct you to optimal strategies for maximizing your profit,” Wille says.
Below, we’re going to look at how unit economics applies to rent. Let’s dive in.
Examples of unit economics vs. average rent for a small business
For the sake of simplicity, let’s avoid spreadsheets and jawbreaking financial acronyms to learn about unit economics. Here are examples boiled down to help busy people to make quick, smart decisions.
- One product costs $5 to produce, stock, and sell. It sells for $10. Looking at the economics of this unit, you can tell there’s a 50% profit margin.
- To acquire one customer, it costs $25, between the online marketing campaign and paying the hourly employees on the sales floor. One customer typically spends $65. Looking at the unit economics, you can analyze your cost to acquire a customer (CAC) might be a little high, but still positive.
- One square foot of space costs $6/month. But in one month your average gross revenue is $48,000. If your store is 1,000 square feet, that’s $6,000 a month in rent. Run the calculation and your rent is 12.5% of your monthly gross income.
Let’s dig into this last example to tell if you’re paying too much rent as a small business.
What percentage of a business’s revenue should be rent?
To calculate this commercial price to rent ratio, we’ll look at two things: (1) your type of business and (2) your competitors. Keep in mind the following percentages are rough and not exact. Use them as a benchmark.
- Restaurants: When calculating a good rent percentage for restaurants, the general rule of thumb is your total occupancy cost (rent and additional fees for property taxes, insurances, etc.) should not exceed 6-10% of your gross sales. (source)
- Auto shops: The typical full-service auto shop spends 12-13% of annual gross revenues on rent. (source)
- Retail stores: Retailers should target a base rental rate that is no more than 5-10% of gross annual sales. (source)
- Law firms: Attorney offices should expect to pay 6-7% of gross revenue, and even up to 15% for a prestigious address. (source and source)
- Hair salons: Rent and property taxes should range from 3% for a remote location to 10% in a well-trafficked mall. (source)
Knowing these benchmarks, the next figure we need is gross sales. Finding this number is easy. How much money did your business make last year? What was the total sales for each month? Some small business owners will know this figure off the top of the head.
The last figures you’ll need is your business’s square footage and rent cost. We’ll provide different sums for the sake of illustration.
Finally, here’s the simple calculation to determine if you’re paying too much in rent.
Gross sales / square footage = sales per square foot
If average monthly gross sales are $50,000 for a 6,000 square foot restaurant (average size for a Ruby Tuesday), then sales per square foot is $8.33.
If rent is $2/square foot, divide it by sales per square foot to get your percentage of income that goes toward rent.
2.00 ÷ 8.33 = 24%
If this number is greater than the benchmark for your industry — restaurants, in this example, at 6-10% — then you can see you are paying too much in rent.
In our example, the restaurant is paying far too much in monthly rent. For every $8.33 in revenue that a square foot generates, $2.00 or nearly one-fourth of that is going to the landlord. This is too much, according to the industry average.
This calculation shows the unit economics of your rent, broken down into the revenue and expense of a single square foot. Why is this important? The restaurant owner in our example can now use the unit economics of their space to negotiate a lower rent agreement with the landlord.
Calculate how much your business should pay in rent
Use unit economics to calculate the return on each part of your business by analyzing the revenue and expense incurred by a single unit. Units can be anything.
In this article we focused on rent and the basic unit of a square foot, but you can use unit economics to analyze the return per employee, per desk, per customer, per product, per hour, etc.
With Womply, you can input a few simple numbers and our business intelligence software will automatically calculate your rent-to-revenue ratio, revenue per square foot, revenue per employee, and advertising-to-revenue ratio. Learn more, plus get free reputation monitoring and customer insights when you sign up for Womply Free!