Valuing leasing risks in commercial property with a discrete‐time binomialtree option model
| Published date | 01 April 2004 |
| Date | 01 April 2004 |
| Pages | 173-191 |
| DOI | https://doi.org/10.1108/14635780410536179 |
| Author | Tien Foo Sing,Wei Liang Tang |
| Subject Matter | Property management & built environment |
Valuing leasing risks in
commercial property with a
discrete-time binomial
tree option model
Tien Foo Sing and Wei Liang Tang
Department of Real Estate, National University of Singapore, Singapore
Keywords Default, Risk management, Options markets, Rent controls, Contracts, Leasing
Abstract This paper models the lessee’s default options and estimates the economic value of the
options for a lessee using a discrete time binomial American option pricing model. Results show a
positive relationship of the option premium with the original rent and a negative relationship with
the relocation costs. Finds that the default probability is higher for lessees who are more sensitive to
rental changes and place less emphasis on the fitting-out quality. Suggests that rental volatility and
rental growth rate are two significant factors that have positive relationships with the default
option values. The risk-free rate, on the other hand, has an inverse relationship with the default
option values because a higher risk-free interest rate reduces the present value of rental savings.
Lease term length to expiration has a positive effect on the default option value, implying that the
default option premium will decay as the term to expiry is shortened.
Introduction
In any lease or tenancy agreements with breaking provisions, tenants are implicitly
granted an option to default on the obligations stipulated in the lease agreement anytime
prior to the expiry of the lease period. This option is particularly valuable in a down
market, where there is a possibility that market rent may fall below the contracted rent. If
such a scenario occurs, the tenant can default on the existing lease agreement and enter
into a new agreement to lease an alternative premise at a lower rent.
Tenants’ default is one of the leasing risks that have significant economic
implications for profit maximizing landlords whose business objective is to ensure that
their buildings are fully leased and existing tenants are retained at the most preferred
terms of lease. Losing a tenant, from the operational point of view, means leaving the
unit vacant for many months before a new tenant is found to take up the vacant unit.
Even if a new tenant were signed up, the rent negotiated may be much lower compared
to that under the previous tenancy. The landlord will be contractually bound to adhere
to the rental rate for the entire lease period. He will forgo any upside potential when the
market conditions recover. In the process of signing new leases, the landlord will incur
agency fees (usually charged at one month’s gross rent) and also suffer losses in terms
of rent-free concessions given to new lessees in setting up their operations. In a weak
market condition, rent-free concessions of up to four months have been given by some
landlords to entice new lessees to take up leasable space in their buildings. The high
costs incurred as a result of tenants breaking leases make the landlord reluctant to let it
happen[1]. Therefore, it will be useful for the landlord to differentiate the preferred
tenants from those that are more likely to default when a market downturn occurs.
The Emerald Research Register for this journal is available at The current issue and full text archive of this journal is available at
www.em eraldinsight.com/res earchregister www.em eraldinsight .com/1463-578X .htm
Leasing risks in
commercial
property
173
Received 26 April 2002
Revised 07 July 2003
Journal of Property Investment &
Finance
Vol. 22 No. 2, 2004
pp. 173-191
qEmerald Group Publishing Limited
1463-578X
DOI 10.1108/14635780410536179
On the part of the lessee/tenant, default decision is also costly and disruptive.
Relocation costs include costs of hiring movers, productive time lost, cos t of reinstating
existing premises, printing of new corporate accessories and communicating the
change of address to clients, which may all add up to a substantial amount. If the
existing lease agreement does not contain a break clause[2], the lessee will have to
forfeit his security deposit, which is usually equivalent to one-month rent for every
one-year lease, if he chooses to terminate the lease prematurely. Therefore, the lessee
will not default unless he is justified that rent savings from taking up a new lease at
current market rent vis-a
`-vis the rent paid for the existing lease are substantial enough
to offset the relocation costs or the costs of default. Based on the industrial rule of
thumb in Singapore, the difference in rents should exceed a dollar per square foot in
order to induce the lessee to exercise his default option. It will not be worth moving
otherwise.
Technically, there are two differences between lease default and cancellation
options. The first difference lies in the timing and flexibility of exercising the options.
The cancellation option is a European option that can only be exercised at a specified
date, whereas the default option is like an American option, which can be exercised
anytime before the maturity of the lease. “Exercise price” is the second factor that
differentiates a lease default option from a lease cancellation option. If a lessee choose s
to default, he will incur relocation costs and also forfeit his security deposit, whereas if
he cancels a lease at the specified period, he is entitled to use his security deposit to
offset the rents over the lease termination notification period. Therefore, the lease
cancellation option can be construed as a subset of the lease default option. This study
will only focus on the default risks. A discrete-time binominal tree option-pricing
framework will be proposed to price the default option. This framework, however, is
flexible and can be generalized to also analyze the cancellation options. The factors like
size of leasable space, contracted rent and relocation costs, which have direct effects on
the default option value will be numerically analyzed. The numerical analyses will give
interesting insights to the probability of default for different lessee types and different
lease characteristics.
The options to default and cancel a lease are valuable to the lessee. The exercise of
these options will in contrary increase the leasing risks of the landlord. Therefore, it
would be significant for the landlord to recognize and evaluate the leasing risks
associated with the cancellation and default options embedded in the lease contracts.
These risk premiums can be technically quantified and adjusted in a default-free lease
rent so as to aptly compensate him for taking the leasing risks. Otherwise, the landlord
will lose out economically in the events when lessees exercise the options to break the
lease prematurely. By making leasing risks explicit, it would provide a more realistic
expectation for both the landlord and lessee when negotiating for new lease rate,
concessions, and rent rebates. The likelihood of default by lessees could also be
averted, if landlord is able to respond to a downward market trend by offering
reasonable rent concessions/rebates to offset rental savings accrued to the lessees
when they default. This will reinforce the phenomenon of “hysteresis” or “sticky
vacancy” as suggested by Grenadier (1995b).
This paper is organized as follows. Next, past real options literature applying to real
estate leases are reviewed, followed by descriptions of lease terms and also relocation
costs in typical office leases in Singapore. The technical data highlighted in this section
JPIF
22,2
174
To continue reading
Request your trial