October 19, 2017

Local business owners: are you paying too much in rent?

It’s time to address that gut feeling that you might be paying too much in rent. In this article, we’ll explain what ‘unit economics’ are, how to use them to determine if you’re paying too much for your real estate, and how to negotiate a lower rate.

Negotiating gone wrong

If you “just know” you are paying too much in rent, and you try to renegotiate with a landlord, the first thing he or she will say is show me the proof, show me the numbers.

Responding “But I just know you’re charging too much!” is a shortcut to no results and could even antagonize a relationship you do not want to risk jeopardizing. 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.

Why care about unit economics?

“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

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 income should small businesses pay in rent?

To calculate this figure, 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: 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.

8.33/2.00 = 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.

Now it’s your turn

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 Insights, you can add a few simple numbers and our software will automatically calculate your rent-to-revenue ratio, revenue per square foot, revenue per employee, and advertising-to-revenue ratio.

The results will give you the confidence to carry on with your current management strategy or instill in you the courage to make difficult but necessary changes moving forward.

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