The impact of lease structures on the optimal holding period for a commercial real estate portfolio
| Date | 02 March 2015 |
| Published date | 02 March 2015 |
| DOI | https://doi.org/10.1108/JPIF-02-2014-0010 |
| Pages | 121-139 |
| Author | Charles-Olivier Amédée-Manesme,Michel Baroni,Fabrice Barthélémy,Mahdi Mokrane |
| Subject Matter | Property management & built environment,Real estate & property,Property valuation & finance |
The impact of lease structures on
the optimal holding period for a
commercial real estate portfolio
Charles-Olivier Amédée-Manesme
Department of Finance, Insurance and Real Estate, Laval University,
Québec, Canada
Michel Baroni
Department of Finance, ESSEC Business School, Cergy-Pontoise, France
Fabrice Barthélémy
Department of Economics, CEMOTEV,
Université de Versailles Saint-Quentin-en-Yvelines, Guyancourt, France, and
Mahdi Mokrane
Department of Strategy & Research, LaSalle Investment Management,
London, UK
Abstract
Purpose –The purpose of this paper is to demonstrate the impact of lease duration and lease break
options on the optimal holding period for a real estate asset or portfolio.
Design/methodology/approach –The authors use a Monte Carlo simulation framework to simulate
a real estate asset’s cash flows in which lease structures (rent, indexation pattern, overall lease duration
and break options) are explicitly taken into account. The authors assume that a tenant exercises his/her
option to break a lease if the rent paid is higher than the market rental value (MRV) of similar
properties. The authors also model vacancy duration stochastically. Finally, capital values and MRVs,
assumed to be correlated, are simulated using specific stochastic processes. The authors derive the
optimal holding period for the asset as the value that maximizes its discounted value.
Findings –The authors demonstrate that, consistent with existing capital markets literature and real
estate business practice, break options in leases can dramatically alter optimal holding periods for
real estate assets and, by extension, portfolios. The paper shows that, everything else being equal,
shorter lease durations, higher MRV volatility, increasing negative rental reversion, higher vacancy
duration, more break options, all tend to decrease the optimal holding period of a real estate asset.
The converse is also true.
Practical implications –Practitioners are offered insights as well as a practical methodology for
determining the ex-ante optimal holding period for an asset or a portfolio based on a number of market
and asset-specific parameters including the lease structure.
Originality/value –The originality of the paper derives from its taking an explicit modelling
approach to lease duration and lease breaks as additional sources of asset-specific risk alongside
market risk. This is critical in real estate portfolio management because such specific risk is usually
difficult to diversify.
Keywords Simulations, Portfolio management, Lease structure, Optimal holding period,
Real estate, Real estate investment
Paper type Research paper
Journal of Property Investment &
Finance
Vol. 33 No. 2, 2015
pp. 121-139
©Emerald Group Publis hing Limited
1463-578X
DOI 10.1108/JPIF-02-2014-0010
Received 1 February 2014
Revised 10 September 2014
Accepted 12 September 2014
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1463-578X.htm
The authors wish to thank the University of Cergy-Pontoise and Fondation Palladio for their
generous support.
121
Impact of
lease
structures
I. Introduction
The optimal holding period in real estate portfolio management is a topic that has only
recently drawn the attention of both investors and academics. Institutional investors
have only recently realized the importance of appropriately setting a holding period for
managing the risk of real estate assets or, more generally, real estate portfolios[1].
Traditionally, real estate investment had been a rather passive process, with investors
adopting a buy-and-hold strategy for real estate, an asset class capable of generating
relatively stable recurring cash flow derived from rental agreements. The strategy was
to hold real estate for many years, a valid strategy given the large transaction costs and
limited liquidity of real estate investments. Few institutional investors engaged directly
in opportunistic or value-added investments that typically hold on to assets for
relatively short periods. This latter type of investment style was the preserve of
developers, opportunistic funds and specialized REITs. Given the increasing specialization
and sophistication of the real estate industry and to some extent the general perception
that real estate cycles tend to be shorter, investors are giving more attention to the notion
of the ex-ante holding period when investing, essentially by systematically asking the
question “How long do I expect to hold this asset for?”.
However, the critical point to make here is that if the predefined holding period is
short, say five years, the weight of terminal value in net present value calculation is
very important, and the expected risk reflected by this value is also more important.
The impact of the terminal value is much less in a ten-year Discounted Cash Flow
(DCF). In practice, and often for purely technical reasons, a finite holding period
(conventionally ten years in corporate finance) is used in cash flow projections to avoid
an infinitely long (W30 years) cash flow series. Thus, holding periods continue to
be generally treated as a simple parameter usually taken as given and dependent on the
nature of the investor and factors such as transaction costs, taxes and investment style
and risk management. Indeed, typically the choice of a holding period in cash flow
projections usually fits either an institutional investor’s objectives (duration and
liability matching for example), the exit strategy say of a finite life close-ended fund,
or tax or regulatory constraints (some funds or REITs in Europe have to hold on to
assets for a minimum duration for tax purposes).
Investors can also decide to sell an asset for three main reasons:
(1) The asset has been managed intensively and no further asset management is
planned. Asset managers often argue that their work consists in managing an
asset by securing tenants and undertaking the necessary work on the asset,
such as a change in asset use or floor plan, energy consumption, security,
parking, cleaning, etc.
(2) The asset belongs to a portfolio for which an exit strategy was defined initially.
Depending on the portfolio management strategy chosen by the investor, the
policy regardingresale may be different. Core investorsthat were once interested
only in long-term leaseswithout break options sold all propertieswhen the lease
lengths were below a given duration (e.g. five years). An opportunistic investor
who seeks large capital returns might be interested only in properties that
require significant asset management, such as repositioning or refurbishment.
This investor sells properties as soon as these initiatives are complete.
(3) The asset does not fit the portfolio well enough. This might be the case when
too many leasing risks are concentrated into the same period, or when market
rental values (MRVs) are far lower or higher than the current rent.
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JPIF
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