Journal of Real Estate Finance and Economics, 26:2/3, 223±240, 2003
# 2003 Kluwer Academic Publishers. Manufactured in The Netherlands.
Valuing and Pricing Retail Leases with Renewal and
PATRIC H. HENDERSHOTT
University of Aberdeen and National Bureau of Economic Research, Aberdeen, UK AB2Y 3FX
E-mail: email@example.com firstname.lastname@example.org
CHARLES W. R. WARD
The University of Reading, Real Estate and Planning, School of Business Whiteknights, Reading,
UK RG6 6AH
We consider retail leases with landlord overages options, with tenant renewal options, with both and with neither.
We illustrate how the ratio of initial expected sales to the sales threshold can be manipulated to equate the value of
the landlord overage options to that of the tenant renewal option at the same initial rent. Not only are the values
equal, but the cumulative distributions of potential IRRs on the two leases are nearly identical, suggesting that
these leases are equally attractive to risk-averse investors and thus that the same risky discount rate can be used in
valuing the leases. In contrast, the appropriate risky discount rate for the overage lease is calculated to be 75±160
basis points greater than that for the renewal lease.
Key Words: retail leases, valuation, risk neutral discounting, risk discount rates
US shopping center leases are possibly the most idiosyncratic and complicated property
leases in the world. Most of these leases contain both an overage rent clause and at least
one renewal option.
Both the landlord and the tenant can have options to cancel the lease,
and tenants can have expansion, contraction, sublease and other options. These options are
included in the contract because they are ``positive sum games''Ðthe value to the party
receiving the option is greater than the cost to the party ``giving'' the option so that the
latter can be adequately compensated via an adjustment in the rent paid. The source of the
positive sum or net gain can be a reduction in payments to third parties, stronger incentives
for tenants or the landlord to exert greater effort, or better risk sharing.
In a competitive
market, the net gain is passed through to consumers as lower prices.
While a vast literature exists on valuing options in property ®nancial contracts
(especially mortgages), including an empirical literature on the ruthlessness with which
borrowers exercise their options, the analysis of leasing contracts is relatively limited.
this paper, we consider the two most common retail lease options, those on overage rents
and renewals. The overage clause is effectively a series of landlord options, giving him/her
higher annual rents in years when tenant sales are particularly strong (the success of the