After years in retail real estate, I can tell you that occupancy cost has always been the best way to understand how a property really performs. Everything from whether tenants succeed to how much a property is worth comes down to what it costs to occupy the space. Too often, people think it is just the rent. But it is not. It includes a lot of things that change with the market, the economy, and even the weather.
Right now, with inflation, higher construction costs, and tenants trying to get more predictable deals, knowing how occupancy costs work has never been more important.
In this article, I will walk you through how these costs are built, how they change, and what we have learned at RockStep Capital about staying ahead of the changes.
Let’s start with the basics. Occupancy cost is the total dollar amount that a tenant pays to occupy a shopping center. That includes several things. Base rent is usually done in dollars per square foot per year, broken up monthly. Then there is a pro rata portion of property taxes, insurance (both liability and casualty), and then common area maintenance, or CAM.
CAM includes everything from sweeping parking lots to lighting, security, landscaping, and HVAC costs if it is an interior corridor. Repairs to the building, parking lot, or roof sometimes get included, too. Some tenants even add utilities like water and air conditioning. But most of the time, it is just real estate costs, rent, taxes, insurance, and CAM.
Those are kind of the key components. Once you understand that, you can really start to evaluate a property or lease properly.
Now that we know what makes up occupancy costs, let’s look at what causes them to go up or down.
The relationship between market conditions and occupancy costs is pretty straightforward. The occupancy costs will be higher if you are in expensive-to-build or expensive-to-buy geographies, such as metro areas or urban areas. That is because the cost of land and construction is higher. Even if you buy a second-generation property, it will still cost more.
In secondary or tertiary markets, occupancy costs are generally lower. But taxes and insurance can make a big difference. Cook County in the Chicago area and Texas have high property taxes. In contrast, Louisiana has some of the lowest. Insurance can spike in high wind or convection areas like tornado or hail zones, or hurricane-prone coastal regions.
Higher CAM costs also show up in urban areas, especially where utility costs are higher, often like in California.
So when people say occupancy costs are rising everywhere, the real answer is that it depends on the market and the property.
However, market conditions are only one side of the equation. The other side is how tenants themselves are thinking about these costs.
Consumer behavior has not really changed the structure or negotiation of occupancy costs. What has changed is how tenants think about those costs. Today, especially in high-cost markets, tenants want to know exactly what they pay.
Sometimes they will say, “I do not care about triple net. I just want to know what my total occupancy cost is.”
They want a gross number or a not-to-exceed number. That protects them from surprises like a sudden tax hike or a spike in CAM expenses.
The sponsor or the landlord would like a triple net so that if insurance costs, taxes, or common area costs go up, they can pass those costs onto the tenant. Both sides want predictability, but they approach it from different directions.
This shift in tenant expectations ties directly to broader economic pressures like inflation and interest rates, which we must also navigate carefully.
Inflation affects occupancy costs in the sense that it can lead to higher CAM costs. As prices for materials, landscaping, utilities, and lighting repairs all go up, so do the costs passed through to tenants.
Construction costs also rise, leading to higher replacement costs and insurance. And when interest rates climb, there is an inverse correlation between interest rates and real estate value. In other words, when rates go up, the value of shopping centers tends to drop.
Sometimes property taxes will adjust down when values fall, but that usually takes a while. This is why we constantly keep a close watch on both inflation and interest rates. Knowing these challenges, our strategy at RockStep has always been to focus on what we can control.
Overall, when planning long-term plans for a property with an unclear future, you have to implement You are trying to estimate what is going to happen over the next five years in terms of all of the factors that affect valuation.
At RockStep, we do that through..
It is easier to get rent increases in smaller tenant spaces than in larger ones. That is why we strategically favor centers where smaller tenants can drive revenue growth.
On the expense side, we assume a natural increase of two to three percent annually. When we look at a possible sale or refinance, we generally assume interest rates will stay about the same. We never count on rates falling because that is not something we can control.
One of the best examples of how this approach works in real life is our Riverwalk property.
For the Riverwalk Outlets in New Orleans, LA, we bought the property right after COVID had shut down the property for six months and reduced tourist and convention demand. That demand still has not fully returned. Because of that, we have had to accept some rents below what they could have been if demand were similar to 2019.
That is a real example of how important it is to stay flexible and realistic when the market changes. The Riverwalk has taught us to adapt quickly without compromising long-term goals.
Another part of adapting is keeping up with what tenants now need to compete in today’s retail world.
One of the key things we look at when evaluating a tenant’s performance is the health ratio. The health ratio is occupancy costs divided by sales. It tells you what percentage of a tenant’s revenue covers their rent, taxes, insurance, and CAM.
This number really matters. A 20 percent health ratio is unsustainable for most tenants and a sign that they will probably move out when their lease expires. If tenants spend that much just to be in the space, they are probably not making money. And if they are not making money, they are not going to stay.
On the flip side, if the number is low, that can be a good thing. A low health ratio, like five percent, might mean you can bump rents and they’ll still stick around. That gives you room to increase income without putting the deal at risk. We use this ratio all the time, whether we are deciding how to structure a renewal, determining if a tenant is likely to stay, or underwriting a new acquisition.
Omnichannel tenants, those with a combination of bricks and mortar and an e-commerce fulfillment strategy and a great app, are the ones that have survived. These tenants not only made it through Amazon’s growth but also grew their e-commerce against Amazon.
Experiential tenants are also a bigger and bigger part of retail space. Since fewer people are making regular shopping trips, you have got to substitute it with tenants who provide experiences. That is something we actively look for when we lease our spaces today.
As the tenant mix evolves, it is just as important to help new investors understand how to navigate this complex environment.
I’ll be frank: finding the right balance with operating costs and fluctuating market conditions is tricky. My advice is simple. Underwrite carefully and be conservative. You have got to look at other types of opportunities in commercial real estate, but shopping centers are very compelling because of positive leverage and the right dynamics of supply and demand.
With very careful underwriting of the base case, shopping center investments are a good choice for new investors. And with all the volatility in the market, putting money into income-producing real estate and taking some money out of the market is a prudent choice to grow and protect wealth.
And when it comes to the future, I see some clear trends ahead.
I do see occupancy costs rising in some markets because of the shortage of retail space. The biggest increases will come in urban markets and those showing significant population growth. In markets with more available space, occupancy costs will likely stay the same.
At RockStep, we plan for both scenarios. We have learned that success comes from understanding the fundamentals like land costs, construction, taxes, and tenant needs. But it also comes from adapting quickly, working with tenants, and staying flexible when things change.
That is where I see things heading, and it is what we plan for every day at RockStep.