Cost issues like the monthly rent, capital improvements and maintenance expenses are often at the forefront of tenant strategy when considering double or triple net-lease arrangements.
However, an additional expense—occupancy costs—are just as important. “Occupancy costs is a metric that helps quantify a tenant’s merchant health, especially relative to their operating performance, within their merchant category and over time,” according to Mark Sigal, CEO of Datex Property Solutions.
However, the occupancy costs metric is on the rise for retail pharmacies and dollar stores. Connect CRE asked experts why this data point is expanding and what potential solutions are to arrest the increase.
What Are Occupancy Costs?
Here’s what the occupancy costs metric is not: It doesn’t measure buildout or tenant improvement expenses.
“Tenant improvements and build-out costs are capital expense items and typically one-time outlays prior to opening,” explained Axiom Retail Advisors Broker Paul Bartlett. “They, along with other items like furniture, fixtures and equipment (FF&E), become the depreciation expense line in the profit and loss but aren’t considered occupancy costs.”
Here’s what occupancy costs measures: “It involves rent, landlord marketing contributions, common area maintenance, taxes and insurance,” Bartlett said.
Occupancy costs is a percentage that is calculated as follows:
Tenant Base Rent + Pro-Rata Share of NNN Expenses/Tenant Reported Sales
Going further, Sigal pointed out that the opportunity costs metric:
“Because occupancy costs examines the relationship between the real estate costs and the sales lift provided by a superior location, it’s a cleaner metric than retail sales per square foot data alone,” Sigal added.
Occupancy Costs on the Rise
As with most tenant expenses, a lower occupancy costs metric is desired. During the pandemic, drug and dollar stores were considered “essential businesses.” According to Datex’s numbers, their occupancy costs stood at 2.19% and 9.42%, respectively.
But that was then. Within the past five years:
Jason Maier, Northmarq’s Senior Vice President of Investment Sales, commented that, in his estimation, 4,000 square feet of every retail pharmacy location loses money. “The average store is roughly 14,000 square feet,” he said. “This means that at least 30% of the space they occupy is either not generating enough revenue per square foot, or even worse, is losing money.”
Additional Factors Driving the Uptick
There are multiple reasons why occupancy costs rocketed upward.
Increased Tenant Costs
“On existing stores, we can attribute lower levels of profitability and higher occupancy costs on repairs, maintenance, taxes and, in many states, rising insurance premiums,” Maier said. “For the most part, these tenants self-insure for a large portion of the coverages required under the lease.”
Additionally, a double or triple net lease means tenants have to spend more to keep current. “To remain competitive, tenants must refresh the stores, maintain the buildings, parking lots and HVAC systems,” Maier said. “All of this leads to higher occupancy costs in a high inflationary market.”
Meanwhile, the increased frequency and severity of natural disasters boost insurance expenses. “Rising replacement and repair costs are inflating the cost of claims,” Bartlett said. “Added to that are more stringent underwriting and risk aversion by insurers.”
Higher Rents
Richard Rizika, agency partner and co-founder of Beta Agency, said higher base rents have been common for many tenants, including retail pharmacies and dollar stores. “There is also a shift in lease terms that often favor landlords, given historically low vacancy rates,” he explained.
Furthermore, while landlords are negotiating better lease terms, they’re passing along shopping center operating expenses. “These can include marketing and technology spend, and they’re pushed into the reimbursable triple net bucket,” Sigal explained. This, coupled with an inflationary environment, has put upward pressure on occupancy costs.
Sales Decline
As rents expand, sales decline. According to Datex figures, drug store sales declined by 22.78%, while dollar store sales weren’t far behind, logging a sales decline of 19.18% since the pandemic.
Additionally, an increase in theft is impacting profitability. “In some markets, stores need to lock up their products, which negatively impacts the shopping experience and can lead to store closures,” Maier commented.
Sigal agreed with the assessment, adding that “there’s the argument that by failing to deliver ‘differentiated retail’ experiences, both categories opened the door for more dollars to shift to Amazon and additional Merchant Categories,” Sigal observed.
Then there is increased competition.
“During the pandemic, folks switched to online, and while shoppers have returned to most brick-and-mortar businesses in general, many of those who switched to online pharmacies haven’t returned to brick and mortar,” commented Stephanie Skrbin, a retail broker with Axiom Real Estate Advisors. “Consumers are finding that online purchases tend to be less expensive and more convenient,” she added.
“Today’s shoppers have more options for purchasing school supplies, office supplies and greeting cards, including online and delivery,” Maier added. “The delineation between pharmacy revenue and convenience revenue has become skewed.
The Results?
Higher occupancy costs are driving drug and dollar stores to act by closing down unproductive locations. “Cost pressures, combined with falling foot traffic and competition from online and discount retailers, make it difficult to justify continuing operations in locations with increasing occupancy costs,” Rizika pointed out.
At the same time, tenants are renegotiating leases and downsizing their footprints. “Some are also focused on growing online and operations to reduce reliance on physical stores,” Rizika said.
Those stores that haven’t closed down have been taking other steps. Said Sigal: “Many operators are reducing in-store staffing, which has resulted in poorer merchandising and a rise in in-store theft, which has led to more lockdown of inventory, further diminishing the retail experience in these categories.” Unfortunately, this path means consumers might flock to competitors. “Merchants that fail to deliver a worthwhile consumer experience are doomed to fail,” Sigal commented.
What’s the Solution?
The experts explained that higher occupancy costs shouldn’t be a retail death knell.
Bartlett suggested that tenant representatives should educate tenants about the current cost environment and ways to lower expenses. Meanwhile, “landlords and landlord reps should be prepared to backfill Rite-Aids, Walgreens and CVS stores now, rather than wait and see what happens,” he advised.
Co-tenancy could also help reduce opportunity costs. “A key benefit of multi-tenant retail is the cross-leverage of different tenants at a shopping center, especially anchor tenants,” Sigal observed.
Then there is technology. “Savings can be found in automation like self-checkout-drones and robots in inventory management,” Bartlett said. Utility expenses could also be reduced by improving fixtures and equipment and adding solar systems, he added.
In all, dollar and drug stores are in a period of transition, much like other retail sectors. Maier noted that during the next five to seven years, as lease deals come up for renewal, there will likely be more store closures and consolidation. This could represent opportunities for investors and owners.
“Unfortunately, there will also be many locations where the current occupancy costs are too high to support the valuation and will be sold at steep discounts,” Maier added.