Lease Terms, Option Pricing and the Financial Characteristics of Property

Abstract

Traditional and standard discounted cash flow valuation techniques are unable to deal with a variety of options contained in lease contracts. In the United Kingdom the most important embedded option is the upward-only rent review. This becomes more valuable to the landlord in an era of low demand and low inflation, as nominal market rents are more likely to fall. Lease contracts are freely negotiated between landlord and tenant, and alternative forms of rent review clause would fundamentally change the investment characteristics of property. Many other less common options also exist in lease contracts and these create further valuation difficulties. It is essential that property valuation techniques be developed that explicitly value the options in lease contracts.

The sensitivity of UK commercial property values to interest rate changes

“…(1) are assumed to be annual in arrears and perpetual with default and void risks captured by the risk premium included in the discount rate. These assumptions simplify the valuation of freehold property but Adams et al (2003) argue they do not fundamentally change the results of the analysis. In a similar way, the holding of property assets for a finite period is ignored.…”

“…The flow-through parameter in the real property duration model, perhaps less obvious to define than in nominal terms, needs to capture the changes in real income caused by factors, such as the distortions in economic and rental growth generated by unanticipated inflation, that also trigger changes in real interest rates, and subsequently real discount rates. The sensitivity of expected real rental growth to changes in real discount rates is also linked to rent review terms (Adams et al, 2003). The rolling over of leases of very short duration, or the inclusion of frequent rent reviews and a clause that index-links the rental changes to a pre-agreed inflation measure, enables the pass through of expected and unexpected inflation to contractual rents (Hartzell et al, 1988).…”

“…The rolling over of leases of very short duration, or the inclusion of frequent rent reviews and a clause that index-links the rental changes to a pre-agreed inflation measure, enables the pass through of expected and unexpected inflation to contractual rents (Hartzell et al, 1988). Index-linked leases enable full pass through of inflation on a yearly basis, so should have high inflation flow-through rates (Adams et al, 2003). The same opportunity exists with short one-year leases, although they provide landlords with less real income certainty than index-linked leases.…”

“…For an application of the concept of duration to equities see Leibowitz, Sorensen, Arnott, and Hanson (1989). The application to UK property can be found in Hamelink, MacGregor, Nanthakumaran and Orr (2002), Brown (2000) and Ward (1988), while Adams, Booth, and Venmore-Rowland (1993) and Adams, Booth, and MacGregor (2003) derive a force of interest volatility measure for freehold interests from a growth explicit discounted cash flow model, assuming quarterly in advance rental payments, which Adams et al (1993) demonstrate is mathematically equivalent to duration. Both Hamelink et al and Brown acknowl-edge that the duration measure is useful only for infinitesimal changes in interest rates.…”

Leases with upward-only characteristics

“…The upward-only lease has been analysed by several authors (notably Baum et al, 1996;Ward and French, 1997;Ward et al, 1998;Adams et al, 2001;Walsh 2001a, 2001b;Ambrose et al, 2002). In terms of the pricing formula derived, best practice is arguably the paper by Ambrose et al (2002), which is also the most recent paper.…”