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Pricing upwards‐only rent review clauses An international perspective

Pricing upwards‐only rent review clauses An international perspective Complicated leasing terms make both the valuation of lease contracts and the calculation of effective rent levels difficult. These complications are compounded by the existence of option‐like features in many contracts. For example, retail leases in the USA generally have overage rent clauses that allow the landlord additional rent if sales exceed a breakpoint, but set a minimum rent level under any sales conditions. Similarly, upward‐only rent review clauses are common in the UK and Australia (as well as other commonwealth countries). Here the rent is fixed at the commencement of the contract, with the option to review the rental figure in line with market conditions at pre‐determined intervals (normally every five years). If rents in the market have increased over the interim period, the rent of the subject property will be adjusted upwards accordingly and this higher level becomes the minimum possible future rent. However, if market rents have either remained static or decreased, the landlords would choose not to operate the rent review clause and the existing rent will continue. The US overage contract can be valued using a binomial approach. The upward‐only adjusting leases cannot because the value of the option is “path‐dependent”. Here, Monte Carlo valuation methods must be used. In this paper we describe both approaches. We show the relationship between the rents on these contracts relative to those without overage or with up and downward adjustment. The key determinants in establishing this relationship are the expected drift and the volatility of either sales (in the case of overage) or market rents (in the case of upward‐only leases). http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Journal of Property Valuation and Investment Emerald Publishing

Pricing upwards‐only rent review clauses An international perspective

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Publisher
Emerald Publishing
Copyright
Copyright © 1998 MCB UP Ltd. All rights reserved.
ISSN
0960-2712
DOI
10.1108/14635789810237556
Publisher site
See Article on Publisher Site

Abstract

Complicated leasing terms make both the valuation of lease contracts and the calculation of effective rent levels difficult. These complications are compounded by the existence of option‐like features in many contracts. For example, retail leases in the USA generally have overage rent clauses that allow the landlord additional rent if sales exceed a breakpoint, but set a minimum rent level under any sales conditions. Similarly, upward‐only rent review clauses are common in the UK and Australia (as well as other commonwealth countries). Here the rent is fixed at the commencement of the contract, with the option to review the rental figure in line with market conditions at pre‐determined intervals (normally every five years). If rents in the market have increased over the interim period, the rent of the subject property will be adjusted upwards accordingly and this higher level becomes the minimum possible future rent. However, if market rents have either remained static or decreased, the landlords would choose not to operate the rent review clause and the existing rent will continue. The US overage contract can be valued using a binomial approach. The upward‐only adjusting leases cannot because the value of the option is “path‐dependent”. Here, Monte Carlo valuation methods must be used. In this paper we describe both approaches. We show the relationship between the rents on these contracts relative to those without overage or with up and downward adjustment. The key determinants in establishing this relationship are the expected drift and the volatility of either sales (in the case of overage) or market rents (in the case of upward‐only leases).

Journal

Journal of Property Valuation and InvestmentEmerald Publishing

Published: Dec 1, 1998

Keywords: Leases; Monte Carlo simulation; Rent review

References