Pricing lease clauses – The prospect of an art becoming science

Published date01 April 2000
Date01 April 2000
AuthorPatrick Rowland
Subject MatterProperty management & built environment
Conference papers:
Pricing lease
Journal of Property Investment &
Finance, Vol. 18 No. 2, 2000,
pp. 177-195. #MCB University
Press, 1463-578X
Pricing lease clauses
The prospect of an art becoming science
Patrick Rowland
Department of Property Studies, Curtin University of Technology, Perth,
Western Australia
Keywords Rental values, Lease, Clauses, Negotiating, Pricing, Risk
Abstract This paper reviews the literature which models lease covenants using option-pricing
techniques, probabilistic measures of risk and the contractual misalignment of incentives. These
quantitative models, in conjunction with conventional discounting mathematics, offer ways to
gauge the effects on rent of changes to many lease clauses. With the exception of discounted cash
flow analysis to adjust rents for leasing incentives, none appears to be used in practice yet. The
program has been designed to bridge the gap between academic developments in this field and
current practices in rental valuation. The program works from rental values set on benchmark or
standard lease conditions in that market and adjusts for different clauses. The program displays
all the stages in calculating the effects of each changed clause and operates entirely from
parameters set by the user. Trials of this program are described.
Part 1: Introduction
In many countries, valuers are called on to assess open market rental values for
mid-term rent reviews, for options to renew at market rent and to advise
landlords and tenants negotiating new leases. Rental assessments are made
largely by comparing with recent lettings of similar premises, adjusting for
distinguishing features of the premises and the lease clauses (Australian
Property Institute, 1998, p. 244)[1].The effects of each physical feature can often
be measured by analysing the rental evidence, supported by an understanding
of the needs of the parties and cost variations. There are rarely, if ever,
sufficient comparable rents to isolate the effect of each lease clause.
Without other methods by which to quantify the effects on rent of unusual
lease clauses, valuers resort to unsubstantiated rental adjustments (passed off
as the valuers' art, gut feeling or some similar euphemism). Further, because
valuers and property advisers have no established methods of converting lease
covenants to a rental equivalent, leases tend to remain in standard forms. This
may be detrimental to both landlords and tenants (Lizieri et al., 1997, p. 32).
Although models of the effects of lease clauses on rent have been developed,
they have remained largely of theoretical interest to date. However, some
academics appear confident that the pricing of the legal rights over real
property will become routine in the near future[2]. This workshop will explore
the prospect of these models being applied to rental adjustments for leases with
unusual clauses, either to support or in the absence of comparable rents. A
prototype of an operational model that reduces changes in lease covenants to
their rental equivalent will be demonstrated.
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The second part of this paper reviews the recent advances in lease modelling
and the pricing of lease covenants. The third part explains the rationale and
main features of the operational model. The fourth part of the paper outlines
how the adjustments to rent are calculated for each of the major lease
covenants. The fifth and final part describes some initial trials of the model,
reports on the sensitivity of the variables and suggests how the model might be
developed further.
Part 2: Pricing lease covenants ± the literature
Changes to lease clauses influence rental value because they shift
opportunities, responsibilities and risks between the two parties. In recent
years, several lease covenants have been studied and their effects on rent
modelled, although not all the approaches have immediate practical relevance.
The covenants that have received most attention are options to renew or to
break leases, the rent reviews provisions, leasing incentives and the liability for
property responsibilities and expenses[3].
Options to renew or break leases
The most extensively researched lease terms have been options to renew or to
break the lease. These give tenants flexibility and, if the rent at the start of the
option is a fixed amount, these options can be priced in a similar way to options
or warrants to buy shares at an exercise price that is fixed when the option fee
is paid (Grenadier, 1995, p. 298). The Black-Scholes and the binomial option-
pricing models do not require a subjective risk-adjusted discount rate,
assuming that the parties can arbitrage between taking an option and buying
the asset combined with a risk-free investment or with a loan (see, for example,
Hull, 1997, p. 156; Peirson et al., 1995, p. 477).
The equivalent of the fee for the option is the increase in the initial rent paid
for the right to renew or to break. In equilibrium in a perfect market, these
options do not create extra value but merely shift value from landlord to tenant,
which should be reflected in increased rent.
An option to renew a lease can be evaluated as a call option for the tenant.
The increase in rent will be determined by the present value of any difference
between the market rent at the time of renewal and the ``exercise price'' being
the agreed rent after renewal. The more uncertain is the difference between the
market rent at renewal and the ``exercise price'', the greater is the value of the
option to renew. Grenadier (1995, p. 318) does not offer a closed form solution to
the pricing of options to renew or break but suggests simulation or numerical
integration to price the option. Buetow and Albert (1998, p. 257) demonstrate
the use of partial differential equations to price options to renew at a rent that it
is based on an index such as the Consumer Price Index.
If the rent after renewal is the then current market rent, the option has no
value using these option-pricing models (Buetow and Albert, 1998, p. 254).
However, the option has a value to the tenant which is related to the present
value of the reestablishment costs and the loss of locational goodwill. It has a

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