Valuing options in commercial real estate leases

Jing Wang and Frederik Pretorious

ERES from European Real Estate Society (ERES)

Abstract: With increased understanding of the relationships between economic behavior, the real estate sector and individual businessesí real estate finance decisions, lease negotiations and the requirements of flexibility are expected to intensify. This has increased the importance of understanding explicit and implicit options in real estate lease contracts and the valuation of such options. This paper addresses option valuation problems in commercial real estate leases, and focuses on the valuation of one common option embedded in commercial real estate lease contracts, namely the tenantís option to renew at the future market rent. Until relatively recently there have been only limited studies done in this field, with some researchers proposing formal models to price renewal options in commercial real estate leases, without being able to solve the pricing problem explicitly when the strike price is defined as the market price at lease expiration. We investigate the value of this option from an economic and financial perspective and identify key determinants of the option value ó transaction costs, vacancy costs, rental income and the purchase substitute. Under the incomplete markets assumption, we propose that the integrated method, which combines the real option approach and decision analysis, can be applied to develop a model to value the option to renew at future market rent, given the characteristics of commercial real estate assets and the key factors.

JEL-codes: R3 (search for similar items in EconPapers)
Date: 2004-06-01
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