Are You Charging Yourself ‘Fair Market Rent?’

The wealthiest independent tire dealers I’ve met always owned most of their own real estate. They lived in and around the market areas that their stores were in, so they knew the good locations with the best demographics and highest traffic patterns.

They also could predict  future growth areas and those in decline. And since most leases call for the tenant to pay rent, taxes and insurance, why not own it, too? Makes sense.

When it comes time to sell, sometimes the value of that real estate is worth more than the value of the business. But since both are valuable assets, maximizing their value is important.

To maximize value, you need to charge the tire business fair market rent on real estate that you own. This will have the tire business operating with a real-world expense structure and the real estate will be at an acceptable rate if you choose to sell or lease it.

Not charging fair market rent may lower your gross profit margins and profits because you might be pricing tires and service based upon a fictional cost structure. Here’s how: Imagine a retail tire dealer with 10 great, visible locations in a secondary market in the middle of the country doing about $18 million annually. ($1.8 million per store is pretty good average sales per store.)

An analysis of the stores’ recast EBITDA - which is a proxy for real profitability - shows it to be 5.0 % or $900,000 on that $18 million of revenue. On further analysis, we see that the dealer’s rent expense is only 3.5% rent-to-sales or $630,000 annually because the owner of those locations simply has not raised rents in many years.

Now, I’m used to seeing 5.5% rent-to-sales on the low end to upwards of 12% or more in western markets, so there is a chance that the owner could legitimately raise the rents an additional $630,000 annually to 7% rent-to-sales, for a total of $1,260,000 annually.

To arrive at fair market rent, the owner really should consult a local commercial real estate broker or pay for a full-blown appraisal of each property. All of this can help validate fair market rent.

But let’s see the impact this new rent now has on recast EBITDA. The EBITDA before the rent was raised is $900,000,, but increasing rent by $630,000 lowers this to $270,000 or a paltry 1.5% to sales.

Applying a market multiple to this lower EBITDA level will simply not result in a maximizing exit.  Charging fair market rent exposes a business that is not as profitable as the owner thinks it is nor as profitable it could be. It’s likely that those great, average sales per store figures are because retail pricing is way lower than the competition.

This retail tire dealer has a lot of work to do to get that EBITDA closer to the 10% that I would look for.

Let’s examine the positive impact that fair market rent has on real estate value. Real estate appraisers typically use three methods for estimating value: the cost method, the comparable sales approach and the income capitalization approach.

The cost method takes the value of the land and then adds up what it would take to construct a building and the comparable sales method analyzes what other similar properties have traded for recently in the area.

But many times, it is the income capitalization method that holds the most sway in determining the value of retail locations, particularly when the location is under a long-term lease. With income capitalization, you take the annual net operating income stream from the property and divide it by the appropriate capitalization rate, which is sometimes 7% for retail tire locations. Cap rates are impacted by the credit worthiness of the tenant, the structure of the lease, the property type and many other variables.

Continuing with the same example above, taking $630,000 in annual rent and dividing that by a 7% cap rate gets an original value for those 10 properties of only $9 million. But when the rent is raised to $1,260,000 annually and the business is shown to make a sustainable and reasonable profit at that rent level, then the new value is now $18 million. On the face of it, $18 million for 10 great, visible retail locations still sounds low to me, but it’s a lot better than $9 million, right?

Charging fair market rent for your real estate is important because many strategic acquirers will want to buy your business, but lease the real estate from you for up to 10 years or more. Don’t wait until the last minute to charge yourself fair market rents because both your business value and real estate value depend on it.