Commercial Real Estate Valuation and Development with Leasing Uncertainty

A theoretical model of commercial property valuation is developed where individual property owners are price takers with respect to the spot lease price, new tenants randomly arrive to lease space, and existing tenants may choose to vacate space. The timing of tenant arrivals and departures is uncertain, the probability of which is determined stochastically based on the relative values of the lease and reservation prices. Upon tenant arrival, lessors have the option to lease space at the market rate. Both the spot lease and tenant reservation prices are stochastic and correlated and can divert from, but eventually revert to, a market equilibrium relationship. Within this framework, we will examine, through the simulation of the model for competed building values, structural (expected) vacancy rates and their distribution for varying parameters sets, each representing different market conditions or property types. Given the values for completed buildings, we will then examine how potential and existing vacancies, spot lease prices, and tenant reservation prices feedback into optimal vacant land valuation and development decisions. The model will allow for the examination of the factors that drive the development of additional vacant space (speculative building) and/or the development of already leased space, i.e., preleasing to hedge leasing uncertainty.