Pricing the options inherent in leased commercial property: A UK case study

Abstract

This paper sets out the findings of a group of research and development projects carried out at the Department of Real Estate and Planning at the University of Reading and at OPS (Oxford Property Systems, a software development company) over the period 1999Ò2003. The projects have several aims. These are: to identify the fundamental drivers of the pricing of different lease terms in the UK property sector; to identify the main variations in UK lease terms; to identify key issues in pricing leases with different lease lengths and other terms; and to develop a model for the pricing of rent under a variety of lease variations. Although it is possible to model quantitatively both landlordsÌ and tenantsÌ positions, the complexity of the legal and institutional issues that influence the rental impact of lease terms makes a solution to pricing challenging. The approach of valuers and funding criteria also add complexity to the issue and add an institutional dimension to the problem, impeding the adjustment towards rational pricing. The intricacy of these issues possibly explains the conservatism of many market participants towards flexi-leases. However, it also provides a potential opportunity to market participants with the ability to accurately price flexibility in lease terms. The research uses data derived from major databases maintained by IPD and the Valuation Office, interviews and workshops with over 50 market participants (owners, letting and investment agents, valuers and rent review surveyors). The OPS software development work was based on the outputs of this research. A key conclusion of this study is that the relative stability of lease terms in the retail and office sectors reflects a widespread mutuality of interests between landlord and tenant in the status quo. Long leases provide important benefits for most retailers in terms of security of trading position and adequate write-off periods, and the fit-out costs for an office user can also encourage longer leases than might otherwise be optimal. From the landlordÌs perspective, the main factors driving the required ÎcompensationÌ for a lease term amendment include expected rental volatility, expected probability of tenant vacation, and the expected costs of tenant vacation. These data are used in conjunction with simulation technology to reflect the options inherent in certain lease types to explore the required rent adjustment. The resulting cash flows have interesting qualities which illustrate the potential importance of option pricing in a non-complex and practical way. Finally, there are interesting valuation and pricing issues posed by the introduction of a new variable, rental growth volatility, into an appraisal system.