The application of financial theory to the pricing of upward-only rent reviews

Abstract

Traditional and discounted cash flow (DCF) methods of property appraisal do not deal adequately with the option nature of upward-only rent reviews. DCF techniques typically value the higher of the expected market level of rents after future rent reviews and the current rent. However, the expected level of income after a review is higher than either of these quantities because, assuming no voids, the distribution of rents is truncated at the current rent until the lease comes to an end. This feature exhibits the same financial characteristics as a fixed-income security with a call option to exchange the fixed income for the market rent if that is higher. An option pricing approach is developed for pricing this option and then an adjusted DCF method is developed. The option-pricing approach is an improvement on those previously published in the literature because it does not need to make the unrealistic assumption of perfect hedging. The DCF approach requires the input of a risk discount rate, and the option pricing approach requires a parameter which has to be estimated from other investment market data.