Pricing short leases and break clauses using simulation methodology
| Date | 01 August 2001 |
| Published date | 01 August 2001 |
| DOI | https://doi.org/10.1108/EUM0000000005790 |
| Pages | 361-374 |
| Author | Patrick McAllister |
| Subject Matter | Property management & built environment |
Academic
papers: Pricing
short leases
361
Journal of Property Investment &
Finance, Vol. 19 No. 4, 2001,
pp. 361-374. #MCB University
Press, 1463-578X
ACADEMIC PAPERS
Pricing short leases and break
clauses using simulation
methodology
Patrick McAllister
Department of Land Management and Development, Faculty of Urban
and Regional Studies, The University of Reading, Reading, UK
Keywords Leases, Pricing, Simulation, Risk
Abstract This paper examines the changes in the length of commercial property leases over the
last decade and presents an analysis of the consequent investment and occupational pricing
implications for commercial property investments. It is argued that the pricing implications of a short
lease to an investor are contingent upon the expected costs of the letting termination to the investor,
the probability that the letting will be terminated and the volatility of rental values. The paper
examines the key factors influencing these variables and presents a framework for incorporating
their effects into pricing models. Approaches to their valuation derived from option pricing are
critically assessed. Simulation methododology is applied to the rental and capital valuations of short
leases and properties with break clauses. It is concluded that in addition to the rigour of its internal
logic, the success of any methodology is predicated upon the accuracy of the inputs.
Introduction
In the 1990s the commercial property market saw a largely market-led
acceleration in the evolution of leasing and occupational practices with the
proliferation of serviced offices, short leases and break clauses. This has
increased the diversity of investment characteristics produced by commercial
property investment assets. Consequently, in a ``thin'', (increasingly)
heterogeneous, dispersed and``noisy'' market, valuers are faced with the problem
of estimating rental and capital values. Given that the main valuation models
rely upon transaction evidence involving comparable properties, the increasing
diversity of lease sructures exacerbates the methodological limitations of such
models. Previous experience of short leaseholds, over renting, lease in ducements
and abnormal rent review periods, has illustrated how major structural market
shifts tend to be followed by confusion surrounding and new developments in
valuation methodology. Typically, as conventionalpricing methods are shown to
be unable to reflect accurately the financial implications of market change,
problems ofpricing efficiency have emerged.
This paper examines the growth of short leases and presents an analysis of
their pricing implications for commercial property investments. It develops
previous research on the financial implications of break clauses (see McAllister
and O'Roarty, 1998, 1999). The paper identifies the critical variables
influencing the effects of short leases on risk and return and presents a
framework for incorporating their pricing effects using cash flow simulation.
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