Pricing lease agreements incorporating tenant’s downscaling option

2018 ◽  
Vol 11 (3) ◽  
pp. 427-439
Author(s):  
Jussi Vimpari
Keyword(s):  
Option Pricing ◽  
Real Option ◽  
Cash Flows ◽  
Property Market ◽  
Content Type ◽  
Property Owner ◽  
Real Option Pricing ◽  
Option Values ◽  
Break Points ◽  
Occupancy Rates

PurposeThe purpose of this paper is to analyse the problem that arises when a tenant’s space needs will likely change in the future, but the property owner would prefer to continue renting the initial space to the same tenant. The study builds upon ideas on structuring option values into initial rent and proposes a method for evaluating the value of adaptability for both the tenants and the owners.Design/methodology/approachThe methodology is based on real option pricing, and it includes key variables of building adaptability, lease agreement terms and property market information. The methodology explains the importance of understanding the concept of volatility related to space needs and how it affects the tenant’s decision to either remain or vacate the rented premises. Real option pricing theory highlights the problem of using linearly growing expectations for physical assets and the obvious problems that arise with that assumption.FindingsThis paper suggests that the principles of option pricing could be used in valuing building adaptability to find the optimal initial rent from both the owner’s and the tenant’s perspective. It is pointed that the volatility of the tenant’s future space requirements should drive the effective rent paid by the tenant. The paper argues as to why the owner is better off if the tenant can downscale (with building adaptability) their current space rather than vacate the whole space. Additionally, this paper presents the reasons for why the tenant should pay more for a space that has such a downscaling option. Eventually, both the owner and the tenant are better off because, from the tenant’s perspective, unnecessary relocating costs can be avoided, and from the owner’s perspective, unnecessary re-renting costs can be avoided.Practical implicationsThe paper demonstrates how the downscaling option creates value for both the owner and the tenant. The owner benefits from higher average occupancy rates, and during lease break points, only part of the premises has to be re-rented rather than the entire premises. When these higher occupancy rates are transferred into cash flows with relevant market parameters, it is evident how the rates create extra value for the property owner and for the tenant, subject to lease terms.Originality/valueThe owner benefits from the higher rent, even though there might be more lease break points where parts of the building must be rented out. If these kinds of option values can be communicated transparently, it should be possible for the owner and the tenant to agree on such terms.

Valuing retail lease options through time

2017 ◽  
Vol 35 (4) ◽  
pp. 369-381 ◽  
Author(s):  
Jussi Vimpari ◽  
Seppo Junnila
Keyword(s):  
Option Pricing ◽  
Real Option ◽  
Real Life ◽  
Option Valuation ◽  
Content Type ◽  
Life Data ◽  
Property Owner ◽  
Real Life Data ◽  
Different Types ◽  
Lease Contracts

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.

scholarly journals The Sunk Cost and the Real Option Pricing Model

Complexity ◽  
2021 ◽  
Vol 2021 ◽  
pp. 1-12 ◽  
Author(s):  
Songsong Li ◽  
Yinglong Zhang ◽  
Xuefeng Wang
Keyword(s):  
Option Pricing ◽  
Real Options ◽  
Real Option ◽  
Value Function ◽  
Intrinsic Value ◽  
Pricing Model ◽  
Sunk Cost ◽  
Financial Options ◽  
Real Option Pricing ◽  
Option Pricing Model

Although the academic literature on real options has grown enormously over the past three decades, hitherto an accurate real option pricing model has not been developed for investment decision analyses. In this paper, we propose a real option pricing model based on sunk cost characteristics, which can estimate the value of real options more accurately. First, we explore the distinctive features that distinguish real options from financial options. The study shows that the distinguishing feature of the real options is the sunk cost, which does not exist in the financial options. Based on the sunk cost characteristic of real options, we find that the exercise conditions of real and financial options are different. Second, we introduce the sunk cost into the intrinsic value function of real options and establish a new real option pricing model. Finally, this paper also discusses the properties of the intrinsic value function and pricing model of real options. We find that the application of the Black–Scholes option pricing model will overestimate the value of real options.

scholarly journals The securitization of residential rental revenue streams in Europe

2017 ◽  
Vol 10 (4) ◽  
pp. 503-518 ◽  
Author(s):  
Jaume Roig Hernando
Keyword(s):  
Real Estate ◽  
Housing Market ◽  
Risk Sharing ◽  
Rental Housing ◽  
Cash Flows ◽  
Property Market ◽  
Investment Funds ◽  
Content Type ◽  
The Usa ◽  
Residential Market

Purpose The purpose of this paper is to analyze the securitization of rental streams, a new investment and finance product introduced in the USA in 2013 that enables fundraising from large residential portfolios owned by major investment funds and investment banking. The securities are made up of non-performance loans as well as real estate portfolios of financial entities. Design/methodology/approach An academic analysis of the European securitization market is performed, as well as a broad overview of the state of the art of the rental housing market and investment property market. Moreover, a market study of Real Estate Owned (hereinafter, REOs) and Real Estate Debts is carried out to determine both the present framework and future trends. Various financial entities and real estate management companies are examined through interviews and data collection to assess the reality of distressed assets and residential portfolios owned by major investors. It introduced the Broker’s Price Opinion concept, de loan-to-value concept and the London Interbank Offered Rate. Findings REO-to-rental securitization is a step forward toward the democratization of finance through the globalization of the residential market, improving risk sharing for major and retail investors. The securitization of rental streams in Europe has not taken off, despite several issuances in the USA since 2013 with significant success where first tranches obtained a credit qualification of triple-A from the majority of the main rating agencies. Originality/value At the end of 2013, a global investment firm launched an innovative finance and investment vehicle that securitized the cash flows originating from leased residential properties. That issue resulted in considerable success and in the development of a new alternative and innovative financing source for real estate activity. Taking into account that housing is a primary need of our society, there is a strong motivation for improving the residential market, and thus, REO-to-rental securitization could help take a step forward in making the housing market more efficient.

Real option pricing with mean-reverting investment and project value

2013 ◽  
Vol 19 (7-8) ◽  
pp. 625-644 ◽  
Author(s):  
Sebastian Jaimungal ◽  
Max O. de Souza ◽  
Jorge P. Zubelli
Keyword(s):  
Option Pricing ◽  
Real Option ◽  
Real Option Pricing

scholarly journals Replacement Analysis of Mutually Exclusive Projects of Unequal Lives Using Kelly Specific Real Option Criterion

2021 ◽  
Vol 2021 ◽  
pp. 1-9
Author(s):  
Gyutai Kim ◽  
Seong-Joon Kim ◽  
Jong-Ho Shin
Keyword(s):  
Option Pricing ◽  
Time Horizon ◽  
Real Option ◽  
Traditional Approach ◽  
Kelly Criterion ◽  
Engineering Economics ◽  
Real Option Pricing ◽  
The Interest Rate ◽  
Binomial Lattice ◽  
Selection Of

This paper presents a model to address the uncertainty inherent in replacement problems, whereby a firm must select between mutually exclusive projects of unequal lifespans by applying the Kelly criterion (which is not well known to the engineering economics community) within a binomial lattice option-pricing environment. Assuming that only the interest rate, among many factors, is uncertain, Brown and Davis performed an economic analysis of this problem by employing a real option-pricing method and argued that their model yields results opposite to those yielded by the traditional approach. However, the results yielded by the model proposed herein are consistent with those by the traditional approach, unlike Brown and Davis’s model. The conclusion is that since the investment time horizon is infinite, a firm rationale pertaining to the selection of the best method for the investment problem of such types does not exist.

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