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A Real Option Approach to Pricing Embedded Options in Retail Leases

Author/s: Tien Foo Sing

Date Published: 1/01/2012

Published in: Volume 18 - 2012 Issue 3 (pages 197 - 211)

Abstract

Percentage lease agreements (PLAs) contain lease clauses with payments of a flat base rent plus a variable rent, which is pegged to sales turnover. This paper applies a multi-period binomial tree option-pricing model to value default options in PLAs. In the absence of penalties on lease pretermination, tenants have an implicit call option, if exercised, giving them a right to “break” a lease and move to alternative premises at a lower prevailing market rent. Using a hypothetical PLA lease defined by key input parameters, the value of the tenants’ default option is estimated at 1.08% for a 3-year PLA lease. When sales turnover and relocation costs are simulated using selected random probability processes, the expected option premiums increase by 0.18% to 1.26%. The levels of base rent and the overage rate are positively related with option premiums. The option premiums, however, decline when relocation costs and sale breakpoint increase.

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Keywords

Default Risks - Option Pricing Model - Percentage Lease Agreements (Plas)

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