Valuing renewal options in public industrial leases in Singapore
| DOI | https://doi.org/10.1108/14635780210433472 |
| Published date | 01 June 2002 |
| Date | 01 June 2002 |
| Pages | 222-241 |
| Author | Tien Foo Sing |
| Subject Matter | Property management & built environment |
JPIF
20,3
222
Journal of Property Investment &
Finance, Vol. 20 No. 3, 2002,
pp. 222-241. #MCB UP Limited,
1463-578X
DOI 10.1108/14635780210433472
ACADEMIC PAPERS
Valuing renewal options in
public industrial leases in
Singapore
Tien Foo Sing
Department of Real Estate, School of Design & Environment,
National University of Singapore, Singapore
Keywords Rental value, Lease renewal, Industrial property, Singapore
Abstract Option to review land rents to prevailing market rents and option to renew leases for
another term are two important options embedded in the public industrial land leases in
Singapore, managed by the Jurong Town Corporation (JTC). The land rents of JTC leases are
reviewed every year subject to a cap on the land rent increase. The rent cap, which is historically
lower than the prevailing market growth rate, widens the gap between the contract rent and the
prevailing market rent as the lease progresses. This creates disincentives to the lessor for not
exercising the rent review option, because the option is in-the-money. The rent gap, on the other
hand, is also translated into substantial profit rents for lessees who hold onto the leasehold
interests of industrial lands. By assuming two different probability distributions for the ex-ante
prevailing market rents, the profit rents were simulated to derive at the values of a hypothetical
30-year lease, which range from US$47.93 (S$86.45) per square meter (psm) (Sungei Kadut,
Kranji) to US$236.05 (S$425.74) psm (West Coast Highway). Based on these simulated 30-year
leasehold values and assumptions of other input parameters: equated yield (e= 10 percent), risk
free rate (R
f
= 4.52), volatility of leasehold value (= 15 percent), term of lease ( T= 30 years)
and rental growth cap (g= 7.6 percent), the premiums for the lease renewal options were
estimated to be in a range of US$4.55 (S$8.21) psm to US$22.26 (S$40.15) psm.
Introduction
The Jurong Town Corporation (JTC), the largest public industrial facilities
developer in Singapore, has institutionalized many embedded options into
public industrial leases in Singapore. The options embedded in the JTC
industrial leases are complex and subject to frequent revisions. Upwards-only
rent revision is one of the lease options, the terms of which have been reviewed
and changed several times. Lease renewal or extension option in the form of a
30+30 year lease is another unique feature of the JTC leases that has important
implications on the valuation. Lessees of 30+30 year leases are entitled to
extend or renew the leases on expiry of the first 30-year lease. The option to
renew a second 30-year lease term can be exercised either upfront or anytime
before the expiry of the first 30-year lease subject to the fulfillment of the
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Please forward your comments to the author by e-mail at rststf@nus.edu.sg. The author wishes
to thank Associate Professor Ong Seow Eng and Associate Professor Yu Shi Ming for their kind
comments, and also Miss Kwok Hui Sann for her research assistance. Errors in the paper, if any,
remain the sole responsibility of the author.
Academic papers:
Valuing renewal
options
223
stipulated investment criteria[1]. These embedded options are economically
valuable. It is, therefore, imperative either from the policy makers' or lessees'
perspective, to make explicit the premiums or values associated with these
options.
There are significant economic implications when a lessor agrees on a lease
of 30-year term vis-aÁ-vis an alternative of 30+30 year term. If the lessor opts not
to recognize the value of the renewal option in the contractual rent, he is deemed
as underwriting the call option at zero cost. The lessor faces the risks of default
or pre-termination by the lessee in a down-market while allowing the lessee to
claim the upside benefits when the prevailing market rent increases. There are
provisions in the lease agreements that allow the lessor to revise the contracted
rent to the prevailing market rent subject to a cap of 5.5 percent when granting
the renewal of the second 30-year lease term. However, the premiums associated
with the lease renewal option would not be fully wiped out as long as the
prevailing market rent grows at a rate fasterthan the capped rate of 5.5 percent.
Lessees could still reap profit rents for the second 30-year lease term on
exercising the lease renewaloptions. The lease renewal option can be considered
as an additional ``sweetener'' to a 30+30 year lease with profit rents.
The rent revision with a predetermined cap rate and the lease renewal option
are two important features institutionalized in the JTC leases. There is no
intention in this study to engage in policy debates on the adequacy and
effectiveness of these lease features. However, there are two significant
objectives underlying this study. First, it aims to conceptually examine the rent
evolution process using dynamic simulation models. Second, it applies a well-
developed financial option-pricing model to empirically estimate the premiums
for the lease renewal options embedded in selected JTC industrial leases. The
paper is organized into seven sections. This section sets up the background and
highlights the significance of the study. The following section reviews relevant
literature. The next section gives a brief overview of the JTC and its leasing
policy, with particular reference to the rent revision and lease renewal options.
Two research methodologies are adopted in the study. A Monte-Carlo
simulation model is used in the next section to analyze the effects of different
rent caps on the values of the leases[2]. The following section illustrates how
the Black-Scholes (Black and Scholes, 1973) option-pricing model is adapted to
numerically estimate the premium for the lease renewal option. The
sensitivities of the key variables like the rental volatility, the growth rate and
lease expiration period to the option premiums are analyzed and relevant policy
implications are drawn in the penultimate section. Finally, conclusions are
drawn.
Literature review
The financial option pricing model first developed by Black and Scholes (1973)
has revolutionized the way risks are analyzed in the financial literature. Based
on a risk-neutral framework, which is independent of the utility function of the
investor, the option pricing theory offers significant insights into many
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