Restaurant Rent: How Much is Too Much?

The question of how much rent a restaurant operation can afford to pay is explored using examples of fixed rent and percentage rent. The relationship between gross sales and rent paid is discussed.

In 2002 I wrote a two-part article on restaurant valuation that was published in The Real Estate Finance Journal - Fall 2002. The article is on the HVS International web site and I regularly receive email and telephone calls from people who have read the article and have used the information in it to lower their real estate taxes, negotiate a selling price for a partner buyout, or determine a reasonable amount to pay for the purchase of an existing restaurant business.

One email posed this question: "I am looking at renting a large restaurant that is approximately four years old. In its first year of operation the restaurant did $2,000,000 in sales. Most recently the restaurant did $1,200,000 in sales. The landlord has approached me with the following offer. Base rent of $10,000 per month plus $10,000 per month triple net charges, and $3,200 per month for kitchen equipment rent, which equals $23,200 per month, or $278,400 per year. Is this too much rent to pay when the landlord thinks that sales volume of $1,500,000 can be easily attained and rent would equal 18.6% of annual sales?"

I have owned a restaurant for 28 years and have appraised restaurants and hotels for almost 20 years. Based on my personal experience in the restaurant business I stated in my restaurant valuation article that restaurants cannot afford to pay more than 5% to 8% of gross sales in rent and still have net operating income left over to provide a return on and of the restaurant operator's investment in the business. Applying this percentage rent guideline to the lease terms shown above, in order to afford $278,400 in annual rent the restaurant operator would need to generate annual gross sales as follows:

$278,400 Annual Rent ÷ 5% of Gross Sales = $5,568,000 Gross Sales
$278,400 Annual Rent ÷ 6% of Gross Sales = $4,640,000 Gross Sales
$278,400 Annual Rent ÷ 7% of Gross Sales = $3,977,143 Gross Sales
$278,400 Annual Rent ÷ 8% of Gross Sales = $3,480,000 Gross Sales

Because annual rent is a fixed amount in this example, the gross sales necessary to cover rent over the range of percentages of gross sales declines as the rent expressed as a percentage of sales increases.

The restaurant business, like many businesses, is managed by ratios of expenses to gross sales. There are fixed costs and variable costs that a restaurant owner must control in order to run a profitable operation. The two largest controllable cost categories are cost-of-goods-sold and labor. These two cost categories are called Prime Costs, and the two together cannot exceed 62% to 68% of gross sales if the restaurant is to stay in business and be profitable over the long run. All other expenses together, including rent, or occupancy cost, should be held in the range of 24% to 32% of gross sales if the restaurant is to run at a profit.

Within the category of Prime Costs, cost-of-goods-sold and labor can vary by type of operation, as long as the total of the two does not exceed 62% to 68% of sales. For example, a steakhouse that sells high cost items such as filet mignon, New York strip steak, and fresh Maine lobster may run a food cost of 38% to 40%, but have a labor cost of 22% to 30% of sales and still have a total Prime Cost of 62% to 68%. Conversely, a quick-service restaurant may need more labor to produce low-cost, low-priced food items quickly and labor cost can be 34% to 40%, with a food cost range between 22% and 34%, and Prime Costs stay within the range of 62% to 68%.

To illustrate the effect of paying rent on the profitability of a restaurant I have taken an actual operating statement for a restaurant that operates in owned real estate and pays no rent, and applied different rent percentages to gross sales to examine the effect on net operating income before income taxes, depreciation, and amortization (EBITDA).