The Question of Rent, Part 1

What should my convenience store rent for? 

The question of rent is fundamental to the management and best utilization of the real estate. Real estate here includes the land, store building and fuel service. 

In this article, we will explore what a convenience store can afford to pay in rent and some of the implications for today’s sale-leaseback transactions.

Rent, like all other expenses, must be paid out of earnings. The amount of rent a store can afford is directly related to how much the store earns. A good rule-of-thumb is that a store can afford about 22 percent of gross profit. This is the sustainable economic rent.

For example, the latest Convenience Store News Industry Report shows that in 2013, the average store had $540,894 in gross profit. That means the average store could afford rent payments of about $9,916 per month ($540,894 x 22 percent divided by 12). This is the net rent not including real estate-related expenses such as fire insurance, maintenance and property taxes.  

This sustainable economic rent of $9,916 per month is derived from the store’s earnings capacity and location. This level of rent allows all other costs of the business to be paid and the operator earns a reasonable profit.

Now, let’s compare this to today’s sale-leaseback deals.

Sale-leasebacks are a popular way to raise capital, especially for retail businesses. In a typical transaction, the owner sells the real estate to an investor in exchange for a lease commitment by the owner. According to Real Capital Analytics, the volume of sale-leasebacks peaked in 2007. After dropping to a low in 2009, transaction volume today is again increasing.

Sale-leasebacks are rarely structured to consider the economic performance of the real estate or its actual ability to pay rent. Instead, they are often made to provide an acceptable investment return to the landlord, or new owner. This investment return is measured by the capitalization rate. 

For convenience stores, it’s common to see sale-leaseback deals marketed with 6-percent to 8-percent capitalization rates. The higher the capitalization rate, the better the economic return to the new owner because the store operator, or tenant, is paying more rent.

When is the capitalization rate or the rent too high?

Let’s use a realistic example. Assume we have a 4,000-square-foot store with eight fuel positions. The real estate (land, store building and fuel service) is worth $2 million. The annual gross profit is $677,000. Figure 1 (see above) shows the required sale-leaseback rents at different capitalization rates. At a 6.5-percent capitalization rate, the required rent is $33 per square foot.  The required rent for the same real estate rises to $45 per square foot at a 9-percent capitalization rate.

Based on the rule-of-thumb, this store can afford to pay about $37 per square foot in rent. So, any sale-leaseback deal with a capitalization rate above 7 percent requires more rent than the store can afford. In other words, at capitalization rates above 7 percent, the operator would lose profit.

Another difficulty can arise if the stated value of the real estate is too high. For example, if the sale-leaseback deal were structured with the stated value of the real estate at $2.5 million with no corresponding increase in earnings, the property could afford a maximum capitalization rate of only 5.5 percent, instead of 7 percent.

Convenience stores and gas stations are specially designed real estate. Their value depends on earnings capacity. When the question of rent arises, operators should keep in mind that the rent a store can afford also depends on earnings.

Editor's note: The opinions expressed in this column are the author's and do not necessarily reflect the views of Convenience Store News.