Profit is the key to a fair rent

Assessing the rental value requires precise data on the amount of trade and hence profit of a pub, as Ken Newton explains It has been accepted for many years that public houses are valued by reference to their profits, rather than size, which is usually the case with restaurants, wine bars and night clubs. In recent years, pubcos have researched alternative methods such as linking rent to the size of the accommodation, including trading areas, kitchen, storage/cellar, residential, car parking, garden and the like. However, the profits method is still the correct approach for pubs and is used by arbitrators and independent experts when it comes to third-party determinations. You have to remember that an open market rental valuation is based on what a hypothetical tenant could achieve and not the actual tenant in occupation. Therefore, the valuer's task is assessing what is a fair, maintainable level of trade for the particular outlet ­ this is done by preparing a hypothetical trading analysis, and a profit-and-loss account. Fair, maintainable trade In assessing the fair, maintainable trade (FMT), account is taken of all income streams ­ wet sales, food, machine income, letting and the like. Wet sales include beer, cider, wines, spirits and minerals. Although it is difficult to generalise, on average, the breakdown will approximate to: 75% beer/lager/cider sales, 20% wines and spirits, and 5% minerals. Of course, these figures vary from pub to pub. However, once they have been agreed, it should be straightforward to apply a wet GP (gross profit) margin knowing the purchase and selling prices of each product excluding discounts and deducting VAT. All valuations are carried out on a net-of-VAT basis. Wet gross profit Wet GP margins vary depending on whether the pub is tied or free-of-tie and a small allowance should be made for wastage and pipe cleaning. As an example, tied GPs can range from 45% to 60% (depending on a guest-ale facility). In the London region, GPs average 50% ­ 55%, but there are of course significant regional variations. Free-of-tie GPs vary from 60% to 65%, depending on purchases and discounts available. Generally, regional brewers tie their tenants on all wet products, whereas large multiple operators can achieve high discounts in the free trade and show up to 65% GP with major pub companies showing in the region of 70%. Food gross profit Food GP margins are not so easy to calculate, as the type of offering can vary from something as simple as snack and bar foods through to restaurant-style dining with a la carte menus. The latter is a much more expensive operation, especially if all the food is fresh and therefore subject to higher wastage compared to a frozen product/fast-food style of service. On average, I find that one normally applies between 45% and 55% to total sales, but the difficulty then is calculating food sales achievable by a hypothetical tenant. Machine income Machine income can include all AWPs (amusement with prizes machines, like fruit machines), SWPs (skill with prizes machines such as quiz machines), pool tables, jukeboxes and cigarette machines. Nowadays, most pubco leases say machine income is shared after the payment of rent and duty. Some of the earlier leases allowed the tenant to keep all income and this could go a long way towards paying the rent. It is up to the valuer to decide the number and type of machines that are suitable for the pub, and hence, arrive at a figure for machine income. Letting accommodation Where letting accommodation is available, an estimate has to be on potential occupancy levels and room rates. Expenditure and outgoings Having calculated the FMT and the GP margins, the valuer then has to make allowance for all the costs involved in the operation of the business. These can be both fixed and variable costs, for example, wages, rates, insurance, utilities, cleaning, entertainment and advertising. While the correct approach is to list all outgoings, on average, the total costs vary between 25% and 35% of turnover depending on the style of operation For a small basic wet-led pub, outgoings may be 25%. For a food-led pub with high catering staff costs to cover or a music venue with high security costs, outgoings can be up to 35%. Another consideration is the loss of interest suffered by tenants because their capital has gone towards paying for stock and the like, rather than being free to invest. Net profit After all the costs have been calculated, it's possible to arrive at the net profit and then work out the rental bid ­ that is, what the tenant would bid in terms of the net profit to operate the business. If the premises is set in a prime location and has potential, such as in a city centre or tourist trap, the tenant may have to bid high and then argue over rent at future reviews. Obviously, run-down pubs attract lower bids. In any event, I have never seen bids of less than 45% or more than 55%, and, in most of my third-party determinations, the arbitrator's award has normally been 50%. Example of profits rental valuation Profit from wet sales of £300,000 (a) with a GP of 55% £165,000 Profit from food sales of £30,000 (b) with a GP of 50% £ 15,000 Machine income profit of £15,000 (c) £ 15,000 Total gross profit £195,000 Less costs at 30% of FMT of £345,000 (a + b +c) £103,500 Balance (d) £ 91,500 Interest on tenant's capital: Fixtures and fittings ­ £15,000 Stock and working capital ­ £15,000 Interest total: £30,000 @ 12.5% = £3,750 (e) £ 3,750 Net profit (d minus e) £ 87,750 Tenant puts in rental bid based on just over 50% of net profit, in other words ... £ 44,000 Analysis: A rent of £44,000 equates to about 13% of turnover and, on average, with a FRI (fully repairing and insuring) assignable lease with a tie, equates to 13% to 15% of sales. Free-of-tie rents are marginally higher. Compare these with fully-tied brewery tenancies where rents equate to 9% to 11%.