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Valuing options to renew at future market value: the case of commercial property leases

Author

Listed:
  • Jenny Jing Wang

    (The University of Hong Kong)

  • Jianfu Shen

    (The Hong Kong Polytechnic University)

  • Frederik Pretorius

    (The University of Hong Kong)

Abstract

In this study, we develop and empirically test a valuation model for a commonly encountered option in office leases: a tenant’s option to renew at future market rent (a fair market value) with lease termination as the maturity date. The model integrates decision analysis with real options analysis and market risk with private risks. “Option value” is defined as the private value of the option to either party pre-contract, while “option price” assumes a fair agreement between transacting parties and can be positive (rental premium paid) or negative (rental discount offered). Without manifest expectations, an analysis of a sample of office leases supports the model’s logic with price estimates in a practical range. The tenants’ option price/value is shown to have a negative relationship with the original/renewal lease term; conversely, the landlords’ option value is positively related to the original/renewal term. Comparative analyses show that transaction costs have a positive effect on tenants’ option value and on prices, while vacancy costs and the vacancy period are both positively related to the landlords’ option value and negatively related to price. Market rent is found to have a negative relationship with option price. Overall, this study provides a theoretical analysis and empirical tests of the value of a real option that allows option holders to renew/extend their contracts at a fair market value.

Suggested Citation

  • 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.
    • Handle: RePEc:spr:fininn:v:9:y:2023:i:1:d:10.1186_s40854-023-00479-1
    DOI: 10.1186/s40854-023-00479-1
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    References listed on IDEAS

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