Valuing retail lease options through time. Volatility spread between different types of retailers
| DOI | https://doi.org/10.1108/JPIF-05-2016-0036 |
| Date | 03 July 2017 |
| Published date | 03 July 2017 |
| Pages | 369-381 |
| Author | Jussi Vimpari,Seppo Junnila |
| Subject Matter | Property management & built environment,Real estate & property,Property valuation & finance |
Valuing retail lease options
through time
Volatility spread between different
types of retailers
Jussi Vimpari and Seppo Junnila
Department of Built Environment, Aalto University, Espoo, Finland
Abstract
Purpose –Retail properties are a perfect example of a property class where revenues determine the rent for
the property owners. Estimating the value of new retail developments is challenging, as the initial revenues
can have a significant variance from the long-term revenue levels. Owners and tenants try to manage this
problem by introducing different kind of options, such as overage rent and extension rights, to the lease
contracts. The purpose of this paper is to value these options through time for different types of retailers,
using real-life data with a method that can be easily applied in practice.
Design/methodology/approach –This paper builds upon the existing papers on real option studies but
has a strong practical focus, which has been identified as a challenge in the field. The paper presents simple
mathematical equations for valuing overage rent and extension options. The equations capture the value
related to uncertainty (volatility) that is missed by standard valuation practices.
Findings –The results indicate that overage and extension options can represent a significant proportion of
retail lease contract’s value and their value is heavily time-dependent. The option values differ greatly
between tenants, as the volatilities can have a large spread across tenants. The paper suggests that the
applicability of option pricing theory and calculus should not be considered as an insurmountable barrier any
more, rather a greater challenge for the practical adaptability of the method can be the availability of real-life
data that is a common problem in real option analysis.
Practical implications –The value of extension and overage options varies greatly between tenants.
In general, the property owner can try balance the positive effects from the overage rents to the negative
effects of tenant extensions. However, this study tries to highlight that, as usual, using the “law of averages”
can result into poor valuation in this context as well. Even the data used in this study provide valuable
findings for the property owner as an analytical deduction can be made that certain types of tenants have
higher volatilities and this should be acknowledged when valuing options within lease contracts.
Originality/value –Previous literature in this topic often takes the input data for the option valuation as
granted rather than trying to identify the real-life data available for the calculation.This is a common problem
in real options valuation and it seems to be one of the reasons why option valuation has not been used widely
in practice. This study has used real-life data to assess the problem and more importantly assessed the data
across different types of tenants. The volatility spread between different types of tenants has not been
discussed previously, even though it has a significant importance when using option pricing in practice.
Keywords Real option, Extension option, Option pricing, Overage rent, Retail lease, Revenue volatility
Paper type Research paper
Introduction
Retail properties are a perfect example of a property class where revenues determine the
rent for the property owners. Estimating the value of new retail developments is
challenging, as the initial revenues can have a significant variance from the long-term
revenue levels. The first rental agreements are based on limited customer traffic
information, which can create large variation between predicted and actual revenues.
This revenue spread has implications for both the tenants and the owners. Both
stakeholders try to manage this problem by introducing different kind of options, such as
overage rent and extension rights, to the lease contracts. However, as option pricing Journal of Property Investment &
Finance
Vol. 35 No. 4, 2017
pp. 369-381
© Emerald PublishingLimited
1463-578X
DOI 10.1108/JPIF-05-2016-0036
Received 29 May 2016
Revised 19 January 2017
Accepted 25 January 2017
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1463-578X.htm
LocalTapiola Real Estate Asset Management Ltd has funded this project and provided information for
the case study. KTI provided data for the revenues.
369
Valuing retail
lease options
through time
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