Pricing lease agreements incorporating tenant’s downscaling option

Abstract

Purpose

The 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/approach

The 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.

Findings

This 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 implications

The 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/value

The 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.

Citation

Vimpari, J. (2018), "Pricing lease agreements incorporating tenant’s downscaling option", Journal of European Real Estate Research, Vol. 11 No. 3, pp. 427-439. https://doi.org/10.1108/JERER-01-2018-0003