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The Pricing of Embedded Options in Real Estate Lease Contracts

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Abstract

Leases and rental agreements often have options attached or embedded in them. These options sometimes depend on a number of economic variables such as the consumer price index (CPI), a real estate index and/or the value of real estate underlying the agreement. The evaluation of these options often involves the solution or approximation to a partial differential equation (PDE). This study analyzes the appropriate PDEs which model the situation where the lessee is granted an option to either purchase the property or to renew the lease at a price (rent) indexed to the CPI or some other readily measured economic variable. The PDEs that result from the usual contingent claim asset-pricing framework are derived and numerically solved using the finite difference method with absorbing boundaries. The value of an embedded option to renew a five year lease on class A office space in each of the ternty-five markets for which the National Real Estate Index reports quarterly rental data is estimated. An evaluation of the model’s "Greeks" confirm that the model conforms to financial intuition which provides support for the accuracy of the estimates.

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  • Gerald Buetow, Jr. & Joseph Albert, 1998. "The Pricing of Embedded Options in Real Estate Lease Contracts," Journal of Real Estate Research, American Real Estate Society, vol. 15(3), pages 253-266.
    • Handle: RePEc:jre:issued:v:15:n:3:1998:p:253-266
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    1. Renigier-Biłozor Małgorzata & d’Amato Maurizio, 2017. "The Valuation of Hope Value for Real Estate Development," Real Estate Management and Valuation, Sciendo, vol. 25(2), pages 91-101, June.
    2. Amédée-Manesme, Charles-Olivier & des Rosiers, François & Grégoire, Philippe, 2015. "The pricing of embedded lease options," Finance Research Letters, Elsevier, vol. 15(C), pages 215-220.
    3. Fang Fang & Lu Ruichang, 2009. "Is There a Term Structure? Empirical Evidence from Shanghai Office Rental Market," International Real Estate Review, Global Social Science Institute, vol. 12(1), pages 23-38.
    4. Cheng Few Lee & Yibing Chen & John Lee, 2020. "Alternative Methods to Derive Option Pricing Models: Review and Comparison," World Scientific Book Chapters, in: Cheng Few Lee & John C Lee (ed.), HANDBOOK OF FINANCIAL ECONOMETRICS, MATHEMATICS, STATISTICS, AND MACHINE LEARNING, chapter 102, pages 3573-3617, World Scientific Publishing Co. Pte. Ltd..
    5. Yi-Long Hsiao & Chien-Jung Ting, 2022. "Pricing Rent-to-Own Options with a Barrier Level: Taking Housing Contracts as an Example," Journal of Applied Finance & Banking, SCIENPRESS Ltd, vol. 12(5), pages 1-3.
    6. Liang, Zhaohui & Wang, Wei & Li, Shusheng, 2012. "Decomposition valuation of complex real options embedded in creative financial leases," Economic Modelling, Elsevier, vol. 29(6), pages 2627-2631.
    7. Charles-Olivier Amédée-Manesme & Francois Des Rosiers & Philippe Grégoire, 2017. "Commercial leases, terms and options in the light of game theory," ERES eres2017_175, European Real Estate Society (ERES).
    8. Isil Erol & Kanak Patel, 2007. "Pricing the Default Option of Inflation-Indexed Mortgages Using Explicit Finite Difference Method," International Real Estate Review, Global Social Science Institute, vol. 10(1), pages 48-92.
    9. Drapikovskyi, Oleksandr & Ivanova, Iryna & Renigier-Biłozor, Małgorzata & Źróbek, Sabina, 2020. "How to assess the impact of hope on a change in the use of land on market value?," Land Use Policy, Elsevier, vol. 97(C).
    10. Jenny Jing Wang & Jianfu Shen & Frederik Pretorius, 2023. "Valuing options to renew at future market value: the case of commercial property leases," Financial Innovation, Springer;Southwestern University of Finance and Economics, vol. 9(1), pages 1-35, December.
    11. Kwabena Mintah, 2018. "Real Options Analysis in Residential Property Development Decision-Making in Australia: Perspective of Executives," International Real Estate Review, Global Social Science Institute, vol. 21(4), pages 473-520.
    12. Isil Erol & Kanak Patel, 2004. "Housing Policy and Mortgage Finance in Turkey During the Late 1990s Inflationary Period," International Real Estate Review, Global Social Science Institute, vol. 7(1), pages 98-120.
    13. Ahmed Al sharif & Ruwen Qin, 2015. "Double-sided price adjustment flexibility with a preemptive right to exercise," Annals of Operations Research, Springer, vol. 226(1), pages 29-50, March.
    14. Chuang-Chang Chang & Hsiao-Wei Ho & Henry Hongren Huang & Yildiray Yildirim, 2024. "A reduced-form model for lease contract valuation with embedded options," Review of Quantitative Finance and Accounting, Springer, vol. 62(2), pages 841-864, February.

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    JEL classification:

    • L85 - Industrial Organization - - Industry Studies: Services - - - Real Estate Services

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