Lag vacancy, effective rents and optimal lease term
| Published date | 01 March 1999 |
| Date | 01 March 1999 |
| Pages | 75-88 |
| DOI | https://doi.org/10.1108/14635789910252918 |
| Author | Raymond Tse |
| Subject Matter | Property management & built environment |
Academic papers:
Lag vacancy
75
ACADEMIC PAPERS
Lag vacancy, effective rents
and optimal lease term
Raymond Tse
Department of Building and Real Estate, Hong Kong Polytechnic
University, Hong Kong
Keywords Lease, Rent, Risk
Abstract This paper analyses the choice of the optimal lease term of office property in relation to
expected lag vacancy, periods of rent-free and expected rental income growth. The optimal lease
term is the one that minimizes the expected costs of contract negotiation from the perspective of
landlords. Specifically, it presents an analysis of how to estimate effective rents based on the lease
term, expected lag vacancy and rent-free periods. This study shows that the optimal lease term
tends to increase under the following conditions: when the expected rate of rental growth decreases,
the discount rate increases, or the expected lag vacancy increases. A longer contract duration is less
costly when future rentals are discounted at a higher rate. Altering the lease length will change the
risks taken by the landlord. Thus, contract length can be used as a device for insuring vacancy risk.
Moreover, we find that the optimal lease length is more sensitive to the lag vacancy when the
discount rate is at a relatively high level.
Introduction
Lease term, renewed rent and expected vacancy risk form a cohesive set of
variables in determining the leasing contract of office properties. The cost of
vacancy is important, particularly at times when vacancy rates are
comparatively high. The expected cost of vacancy depends on the expected lag
vacancy multiplied by the rental income for the property. The lease term refers
to the initial contract lease period which varies from two years at the short end,
to as long as 60 years. In a survey conducted by Gallup for Richard Ellis in 1994,
length of lease was cited by two/three of the respondents as one of the most
important factors behind property lending in London[1]. After the primary
lease term expires, units are expected to remain vacant for a period of time,
although how long depends on market conditions. This vacancy in between
consecutive leases is referred to as lag vacancy (Dreyer and Mathieson, 1995). If
Land N, respectively, are the expected lag vacancy and lease term, then the
expected vacancy rate is v = L/N.
The landlord may choose a short-term contract that sets the rent for the first
period only, leaving everything else open to negotiation at the beginning of the
second period; or a long-term contract that fixes the rent for both periods.
However, rent review is less flexible in long-term contracts. A landlord who
anticipates a moderate rise in rents will be more likely to enter into a long-term
lease. If the landlord is averse to risk, he can sacrifice some expected rental rates
for a reduction in vacancy risk in rental renegotiation. It appears that shorter
Journal of Property Investment &
Finance, Vol. 17 No. 1, 1999,
pp. 75-88. © MCBUniversity Press,
1463-578X
Received 20 July 1998
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