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Lag vacancy

Lag vacancy, effective rents

and optimal lease term 75

Raymond Tse

Received 20 July 1998

Department of Building and Real Estate, Hong Kong Polytechnic

University, Hong Kong

Abstract This paper analyses the choice of the optimal lease term of office property in relation to

expected lag vacancy, periods of rent-free and expected rental income growth. The optimal lease

term is the one that minimizes the expected costs of contract negotiation from the perspective of

landlords. Specifically, it presents an analysis of how to estimate effective rents based on the lease

term, expected lag vacancy and rent-free periods. This study shows that the optimal lease term

tends to increase under the following conditions: when the expected rate of rental growth decreases,

the discount rate increases, or the expected lag vacancy increases. A longer contract duration is less

costly when future rentals are discounted at a higher rate. Altering the lease length will change the

risks taken by the landlord. Thus, contract length can be used as a device for insuring vacancy risk.

Moreover, we find that the optimal lease length is more sensitive to the lag vacancy when the

discount rate is at a relatively high level.

Introduction

Lease term, renewed rent and expected vacancy risk form a cohesive set of

variables in determining the leasing contract of office properties. The cost of

vacancy is important, particularly at times when vacancy rates are

comparatively high. The expected cost of vacancy depends on the expected lag

vacancy multiplied by the rental income for the property. The lease term refers

to the initial contract lease period which varies from two years at the short end,

to as long as 60 years. In a survey conducted by Gallup for Richard Ellis in 1994,

length of lease was cited by two/three of the respondents as one of the most

important factors behind property lending in London[1]. After the primary

lease term expires, units are expected to remain vacant for a period of time,

although how long depends on market conditions. This vacancy in between

consecutive leases is referred to as lag vacancy (Dreyer and Mathieson, 1995). If

L and N, respectively, are the expected lag vacancy and lease term, then the

expected vacancy rate is v = L/N.

The landlord may choose a short-term contract that sets the rent for the first

period only, leaving everything else open to negotiation at the beginning of the

second period; or a long-term contract that fixes the rent for both periods.

However, rent review is less flexible in long-term contracts. A landlord who

anticipates a moderate rise in rents will be more likely to enter into a long-term Journal of Property Investment &

lease. If the landlord is averse to risk, he can sacrifice some expected rental rates Finance, Vol. 17 No. 1, 1999,

pp. 75-88. © MCB University Press,

for a reduction in vacancy risk in rental renegotiation. It appears that shorter 1463-578X

JPIF leases afford less protection to the landlord and are tenant-oriented. Entering a

17,1 long-term, non-cancellable lease may reduce the landlord’s uncertainty. Against

this background, the landlord will compare the expected cost of lag vacancy

against flexibility of rent review. There are a number of articles on the

relationship between leasing and rents. Rowland (1996a; 1996b) studies how a

rent, inclusive of property running costs, is adjusted to its equivalent net rent.

76 Benjamin et al. (1995) showed the moral hazard problems associated with a

tenant’s incentive to under-maintain or overuse a leased property. Brown (1995),

using the discounted cash flow model, shows that lease incentives will distort

the rental value market without any effect on the open market valuation of

properties. The model employed by Jefferies (1994) also estimates the effective

rent which has been undervalued. Dreyer and Mathieson (1995), using a simple

one-period model, estimate the lag vacancy rate for a given probability of

renewal. However, the impact of expected vacancy risk on the choice of lease

term remains under-researched.

It should be noted that effective rentals allowing all incentives are

unobservable. Comparisons of the rental costs of office premises require

adjustment of rents to take account of the differing lease terms and varying rent

free periods. The terms of a lease should include any effect of rent-free periods

granted for comparable lettings, and various user restrictions in arriving at the

rental value for the premises. Consideration should therefore be given to

concessions included in the lease contract. Concessions that would overstate the

actual rental received include unusually long lease length, low security

deposits, a longer rent-free period of occupancy, and the provision by the

landlord of expensive interior partitioning in offices. This paper is the first to

provide a theoretical framework which includes highlighting the relationship

between the optimal lease length and the expected lag vacancy; the rate of

rental growth; the rent-free period and risks. The next section shows how the

effective rents can be estimated based on the lease term, expected lag vacancy

and rent-free period. The following sections examine how contract length can

be used as a device for insuring vacancy risk. We will derive the optimal lease

length by balancing the benefits of a shorter lease length against the landlord’s

increased expected contract negotiation costs. Comparative statics are used to

show how the optimal lease length is affected by the parameters of the model.

Concerns expressed in relation to risk factors in choosing a lease term have also

been discussed.

Effective rents

While a tenant will leave after the expiration of one lease term, there is an

expected lag vacancy because the property is unlikely to be rented out

immediately. In order to determine the effective rental value, the most simplistic

approach is to assess the total rent paid by the tenant after the lag vacancy

period and rent-free period has ended and spread this over the total time period.

Thus the lease incentives can be viewed as a repackaging of the rental stream.

The renewal of a lease could be viewed as an option (Brown, 1995)[2].

Assume that the lag vacancy (L) is in the period [0, L] and the rent-free period Academic papers:

(F) is in [L, L + F]. For a lease term N, rental incomes R flow evenly in [L + F, N Lag vacancy

+ L]. Let r be the discount rate. To spread the present value of the total rent paid

by the tenant after the lag vacancy and rent-free period ended over the total

time N, we have

77

(1)

Since the rental income stream R is constant in that period, the effective rent

(ER) incorporating the lag vacancy and rent-free period, can be derived as

follows (Appendix 1):

(2)

subject to N > F > 0 and r > 0. It can be shown that ∂ER/∂N > 0 and ∂EP/∂L < 0

(Figure 1). For example, let r = 10 per cent and R = 1,000. If the expected time

to re-lease the property (i.e. lag vacancy) is three months (then the vacancy rate

is 3/36 = 8.3 per cent) and the rent-free period F is two months, the effective rent

will be ER = 0.913 × 1,000 = 913 for a lease term of three years. This means that

the lag vacancy and rent-free period is equivalent to a cost of 8.7 per cent of the

nominal/face rental income. Suppose the discount rate (r) decreases to 5 per

cent, then the corresponding effective rent increases to 929. Clearly, the effective

rent decreases when the rent-free period increases (Figure 2), but increases

when the discount rate decreases (Figure 3).

In case the tenant renews the lease at the end of the lease term, the lag

vacancy will become zero. This means that the lag is probabilistic. In general,

0.94

0.93

Effective Rent/Face Rent (%)

0.92

0.91

0.90

0.89

0.88

0.87 Key

0.86 I II III

0.85

0.84 Figure 1.

2 3 4 5 6 Effects of expected lag

Lease Length N (Years) vacancy on optimal

r = 10%; F = 2 months; lease length

I: L = 3 months; II: L = 6 months; III: L = 9 months

JPIF 0.97

17,1 0.95

0.93

0.91

0.89

78 0.87

0.85

Key

0.83 I II III

0.81

Figure 2. 0.79

Effects of rent-free 2 3 4 5 6

period on optimal lease Lease Length N (Years)

length r = 10%; L = 3 months;

I: F = 1 month; II: F = 2 months; III: F = 4 months

0.96

0.95

Effective Rent/Face Rent (%)

0.94

0.93

0.92

0.91

0.90

0.89 Key

0.88 I II III

0.87

0.86

Figure 3. 2 3 4 5 6

Effects of discount rate Lease Length N (Years)

on optimal lease length L = 3 months; F = 2 months;

I: r = 5%; II: r = 10%; III: r = 15%

f (x) such that

(3)

The uncertainty of renewal occurs at the review date when the rent is

renegotiated. After that has taken place, the vacancy risk concerning the lease

has been resolved and the rent is then fixed again until the next review.

Optimal lease term Academic papers:

In the period between rent reviews, rents are fixed in nominal terms. The Lag vacancy

landlord is unable to adjust the rental according to market condition if a lease

with relatively long rent review periods is chosen. In this case, the nominal rent

will remain at the current level for some time and cannot increase to

compensate the landlord for higher levels of inflation. On the other hand, the

expected cost of vacancy will be high if a relatively short lease term is adopted 79

because of the risk of lag vacancy on renewal, especially when the property

market is in slump. Moreover, short-term leasing involves higher costs in

searching for information, further negotiation and redrafting documentation.

Especially, concessions, such as rent-free periods, need to be provided when the

leases are renegotiated. The landlord will choose the optimal lease term to

maximize total expected income from the rental property. To simplify the

exposition of fairly complex ideas, this paper assumes that the landlord has two

options: choosing two shorter lease terms, with lease length equal to N and M;

or choosing a longer lease term with lease length equal to (N + M). The

expected lag vacancy, which is independent of the lease terms, is assumed to be

L, and the mean period of rent free is F. We assume that an initial lag vacancy

and rent-free period are involved in every rental negotiation. While a long year

term helps to reduce vacancy risk, short year term allows the contract rent to be

reviewed closely to the effective open market rent. Regarding the initial short-

term lease (lease length = N), the rent (R) is assumed to be reviewed upward by

a rate of g on renewal. For simplicity, we assume that there are no leasing

commissions and expenses for renewing tenants. If the lease term on renewal is

M, the total expected rental income for the two combined lease terms will be[3]:

(4)

If the initial lease term chosen is (N + M) and the lag vacancy is L, the total

expected rental income received is:

(5)

The landlord will prefer the longer lease term to the shorter one on the condition

that Y > X. Combining equations (4) and (5) yields (Appendix 2):

g < (e–rM – e–r(M+L) + e–r(L+F) – 1)/(e–rM – e–rF) e–rF,

where M > L; F and r > 0. However, g is continuous at r = 0, in which case g = 0.

This shows that there is interdependence between the expected lag vacancy,

rent-free period and rental incremental rate while choosing a lease term. For

example, a three-year lease term with an expected lag vacancy of L = three

months would require to arrive at an expected rental rate of growth more than

9.5 per cent (assume r = 10 per cent and F = two months)[4], so that the shorter

JPIF lease term will be chosen (see Table I). In this case, the valuer considers a two-

17,1 year lease contract with an expected rental rate of growth 9.5 per cent as likely

as one of a five-year lease contract. It is interesting to note that the expected

rental rate of growth depends only on (the second lease term) M, and not N.

More generally, g increases when r, L and F increase.

Booth (1993) shows that the present value of property with a longer rent

80 review period will be more sensitive to a rise in inflationary expectations.

Properties with longer rent review periods are closer to fixed interest securities,

since rents are fixed in nominal terms for a longer time period. However, the

present value of a property with different lease terms should be the same

because opportunities for arbitrage will eliminate disequilibrium in the market.

Equilibrium condition implies that g = (e–rM – e–r(M+L) + e–r(L+F) – 1)/(e–rM –

e–rF) e–rF, in which case, the landlord will be indifferent in choosing any one of

the two lease terms. This implies that the expected lag vacancy can be

transformed equivalently into the expected rental growth rate, such that g

increases when L increases. Alternatively, the optimal lease term (M*) to be

chosen by the landlord can be expressed as

(6)

Equation (6) implies that M* is always positive since e–rF < 1. For example, let

r = 8 per cent, g = 15 per cent and F = two months. The optimal lease term M*

increases from 42 to 52 months when L increases from three to four months,

whereas M* decreases from 42 to 35 months when the expected rate of rental

growth g increases from 15 to 18 per cent. In addition, the optimal lease term

increases from 42 to 52 months when the rent-free period increases from two to

three months. More generally, it can be proved that the optimal lease term

increases when the expected lag vacancy and/or the discount rate increases,

ceteris paribus. The relationship between the optimal values of M* and L is

depicted in Figure 4. It appears that the optimal lease length (M*) is more

sensitive to the lag vacancy (L) when the discount rate (r) is at a relatively high

level.

In Figure 5, clearly, ∂M*/∂r > 0. As is seen, the M* function shifts from I to III

when g decreases from 12 to 8 per cent, ceteris paribus. An increase in the

discount rate is to reduce the expected real rental growth rate. The M* function

L = 6, F = 2 9.0 12.3 15.7

Table I.

L = 3, F = 4 14.9 17.4 20.0

Estimates of expected

rate of rental growth (g) Note: Assume M = 36 months

Optimal Lease Length M* (months)

100

Academic papers:

90 Lag vacancy

80

Key

70 I II III

60

50

81

40

30

20

2 3 4 5 6 Figure 4.

Optimal lease term

Expected Lag Vacancy L (months) varies with expected lag

F = 2 months; g = 10%. vacancy

I: r = 8%; II: r = 10%; III: r = 12%

210

Optimal Lease Term M* (months)

190

170

Key

150 I II III IV

130

110

90

70

50

30 Figure 5.

2 5 8 11 14 Optimal lease term

Discount Rate r (%) varies with discount

F = 2 months; I: g = 12%, L = 3 months; II: g = 10%, L = 3 months; rate

III: g = 8%, L = 3 months; IV: g = 8%, L = 3.3 months.

further shifts from III to IV when L increases from 3 to 3.3 months. It should be

noted that the optimal lease term becomes very sensitive to the discount rate

when the expected rate of rental growth is at a relatively low level and/or the

expected lag vacancy is at a relatively high level.

The rent-free periods can also fit into the above analysis. Equation (6) shows

that the optimal lease length increases when rent-free period F increases. There

is a tendency for landlords to offer concessions to tenants rather than lowering

the face/nominal rent and providing the tenant with fitting out allowances. It is

because lowering the face rent for one particular tenant will affect other rental

negotiations[5]. Thus, rent-free period is a more flexible concession in the

contractual arrangements. However, as was discussed earlier, an increase in

JPIF rent-free period actually means a decrease in effective rents. Practitioners can

17,1 use this concept to assess the appropriate lease length, and to estimate effective

rents of different lease terms.

(a) Uncertainty

82 We have shown that there is a cost attached to frequent contract negotiations

that is not present in a long contract. A long lease length can provide the

landlord with a means of guaranteeing a certain level of rental from the

property. Thus, risky cash flow from the property is the major cost of

renegotiating a new contract. However, different properties may have different

volatility of rental movement. Especially properties without rental comparables

in the locality which do not have a rental history may exhibit a more volatile

rental movement. This volatility risk is compensated for by the addition of a

risk premium to the discount rate. It follows that a greater rental volatility leads

to a higher discount rate, which will in turn call for a longer lease term in order

to offset the increased risks. But the risk premium varies with investors’

anticipations of inflation, from time to time and from one property to another.

Fiedler and Schweitzer (1995) argue that the determination of the appropriate

risk premium requires the investor not only to have a view of the current trends

and circumstances of just one asset group, but a judgement of the current

expectations for competitive asset groups as well. The risk premium is strongly

affected by the market expectations. For instance, a decrease in real estate

values generally will lead to a loss of perceived wealth, decline in levels of

optimism and reduction in expectations for future value increases. Such

expectations will in turn bring about a decrease in space demand for offices.

Risk premium can be measured by computing variability in annual return.

With volatile office rental levels, many landlords and tenants are naturally

confused as to where rental levels actually stand when their rent review or lease

renewal approaches (see Smith, 1995, for related discussion). There are errors in

estimating the expected lag vacancy and expected rental growth rate which can

have significant impacts on the choice of lease terms. Property valuations are

usually undertaken in an environment of uncertainty and incomplete

information. It makes sense for a valuer to consider the previous rental income

growth (possibly adjusted for risks) before arriving at the optimal lease length.

Using ex post return premiums over long time periods as proxies for ex ante

premiums is probably the most convenient way we can do this. The exact

measure of rental growth based on expectations is difficult. It is because

expected rental values are likely to be biased: upwards during economic

expansion and downwards during contraction (Born and Pyhrr, 1994). In some

cases, the additional rent may reflect part of an increase in operating expenses

(Murtaugh and Daspin, 1994). Future property operating costs can also be hard

to estimate.

On the other hand, expected lag vacancy has become associated with the

negotiation process. In general, expected lag vacancy and negotiation time

decrease as the time cost of negotiation (discount rate) increases. The discount Academic papers:

rate is the nominal opportunity cost, which incorporates general economy-wide Lag vacancy

inflation, and should contain a risk premium above the return to riskless assets.

It has been argued that the discount rate should also reflect illiquidity or other

sources of disutility in unsecuritized real estate investments compared to

securities (Ibbotson and Siegel, 1984). Office properties, confronted by a greater

dispersion of prices, are expected to have a longer negotiation time. 83

(b) Market structures

The above model assumes that the optimal lease term is the one that mimimizes

the expected costs of contract negotiation from the perspective of landlords.

However, in a competitive market, landlords and tenants can negotiate lease

terms and exchange rental concessions for lease responsibilities to arrive at a

lease structure under which the combined values of the landlord’s interest and

the tenant’s interest are maximized. If the property market is characterised by

oligopoly powers held by a small group of landlords, the owners will be able to

dictate the lease terms, rather than freely negotiate them (Rowland, 1996b).

The effect of oligopoly usually occurs in some highly specialised properties

which are equipped with special design or facilities required by certain

categories of tenants, such as medical practitioners or high-tech operations.

However, the initial negotiation between landlords and tenants also depends

very much on the market conditions. Landlords will be able to pass on to their

tenants most of the operating costs, including the costs due to vacancy risks,

when the demand for office space is strong relative to its supply. However,

during recessionary times, the vacancy risks will be much greater for highly

specialised properties than for general purpose ones. It therefore follows that

specialised properties tend to be leased for longer periods than general purpose

ones (Rowland, 1996b). In general, specialised properties have higher vacancy

risks. Higher risks give rise to a higher discount rate, and therefore lead to a

longer lease term. The landlord’s expected costs of renegotiating a new contract

may rise as a result because the risk of searching for a new tenant presumably

exceeds the benefit of higher rental prospects. The effect on M* of changes in the

discount rate r was shown in Figure 5. Thus, considerations should be given to

the nature of the property in determining the discount rate. Reinforcing this

effect is the fact that a longer contract duration is less costly, when future

rentals are discounted at a higher rate. When the discount rate increases, the

present value of expected rentals is lower for a given contract length. In other

words, an increase in the discount rate will lead to a fall of the marginal cost of

a longer lease length.

The lease term is further complicated by the need to consider the uniqueness of

the locational and physical characteristics of each property as well as the

expected tenancy defaults, the riskiness of market sectors and the legal

intricacies of the contract between landlord and tenant (Crosby and Murdoch,

JPIF 1994; Murdoch, 1994). As was discussed earlier, the discount rate (r) comprises

17,1 the risk-free rate, an inflation consideration and the relative volatility of the

rental income from the property. Investors prefer a reliable, though

conservative, income stream. Thus real estate which gives both high returns

and a high risk may be unattractive. Risk can be classified as either market risk

or specific risk. Market risk comes from external changes which are

84 uncontrollable, but specific risk is the unique risk associated with a particular

investment or portfolio of investments[6]. For example, the expected lag

vacancy of an office building, with nearly all of its leases expiring within a short

period of time, would certainly be higher than one in which the lease expiration

dates were evenly distributed over the next year.

Lease contracts with frequent change of tenants may carry a higher tenant

credit risk because a tenant may fail to pay all of the contractually owed rent.

Landlords can grant a tenure discount to prevent good tenants from moving.

The tenure discount serves to reduce the turnover of good tenants and to

increase the turnover of bad tenants. Conversely, a lower tenure discount

implies a higher tenant credit risk in rental renegotiation, in which case a longer

lease term is desirable. In equilibrium, low rents and a low turnover of good

tenants, as well as high rents accompanied by a high turnover of bad tenants,

contribute to the tenure discount. Bad tenants represent a form of market risk.

Owing to imperfect information, bad tenants have an incentive to conceal their

type in order to obtain more favourable contract terms. Hence, the combination

of a higher tenure discount and a longer lease term could help to reduce the

turnover of good tenants. It should be noted that the quality of the cash flows

for a single tenant building are much more dependent on the quality of the lease

and the relationship with the tenant than are multi-tenant properties.

While many commercial leases comprise a longer term than the average

residential lease, long leases may include provision for the renegotiation of the

rent at specified times during the lease[7]. It is also common to see leases with

an option of renewal only at the end of the tenancy at the open market rent.

However, properties acquired on low initial rental yields with high growth

prospects tend to accompany a short initial lease term. Any landlord who

settles for a bad lease, may actually be devaluing his property by restricting his

income stream for a lease period of three or even five years. A lease with

uneconomical rental terms represents a lost opportunity to boost the value of

the property. Thus, as more favourable market conditions come, landlords tend

to focus not on just filling space but on maximizing and sustaining the value of

their properties by negotiating leases on the basis of a long-term business plan

of value enhancement (Hayman and Ulrick, 1995). If the parties are commencing

a long-term relationship, initial rental negotiation will be more important in

long-term than short-term leases. In general, the lease length, the statutory

rights to renew, and the basis of rent reviews would influence the allocation of

risk bearing between the landlord and tenant. While altering the lease length

will change the risks taken by the landlord, risks can be divided or shifted Academic papers:

through contractual arrangements. The risks will be reflected in the discount Lag vacancy

rate r, thereby affecting the optimal lease term.

A long-term contract also helps to keep the cost of maintenance and

administration low (Hubert, 1995). By contrast, the shorter the lease term, the

greater the likelihood is that the lessee will not fully take good care in using the

property (Flath, 1980). In general, the longer the lease term, the more the 85

effective ownership of the property is transferred to the tenant. DiPasquale and

Wheaton (1996) argue that with a very long lease term, the landlord has

implicitly sold the rights to an uncertain market income stream in exchange for

the present discounted value of all lease payments.

We have shown that contracts with different lease lengths can be valued and

compared. For instance, a landlord may be especially motivated to offer a

below-market rent for an office property; the valuer’s service to the client under

the current practice is to alert the client to the situation and explain that

measuring the effective rental of the contract is not ordinarily undertaken. The

estimates provided are, however, beyond a standard valuation’s scope. A more

comprehensive valuation would help the valuer understand the varying views

of the lease term likely to be taken by prospective landlords and the change of

lease length may be achieved through sensitivity analysis, using the model.

Moreover, valuers cannot avoid considering the future. Valuers not only provide

a one-number answer but address the need for risk assessment in its

complexity. Since risks are valued as direct costs perceived by market

participants, the valuer must also have a feel of the market (Peto et al., 1996).

Conclusions

Rents are fixed within a lease term. The landlord is unable to adjust the rental

according to market condition if a relatively long lease term is chosen. However,

the expected cost of vacancy will be high if a relatively short lease term is used,

especially when the property market is very competitive. Moreover, short-term

leasing involves higher costs in searching for information, further negotiation

and redrafting documentation. Especially, concessions, such as rent-free

periods, need to be provided when the leases are renegotiated. Thus the

landlord will choose the optimal lease term to maximize total income from the

rental property. This paper shows that there is interdependence between the

expected lag vacancy, rental growth rate and rent-free periods while choosing a

lease term. However, the future path of rentals is not known with certainty. An

expected lag vacancy would require a higher expected rental growth rate.

Specifically, the expected lag vacancy can be transformed into a cost which

reduces effective rents.

The optimal lease length is chosen by the landlord to balance the benefits of

a short lease length with the expected cost of renegotiating a new contract.

Risks will, however, be reflected in the discount rate, thereby affecting the

optimal lease term. We show that if two shorter lease terms are chosen, the

expected rental rate of growth does not affect the initial lease term. More

JPIF generally, the optimal lease term tends to increase when the discount rate,

17,1 expected lag vacancy, and rent-free periods increase. However, rent volatility,

bad tenancy, imperfect expectations as well as negotiation process would affect

the predictions of a risk premium in the choice of lease terms through affecting

the expected rental growth.

Although land economists and valuers are expected to benefit from our

86 analysis of the optimal lease term, there are still many problems associated with

the estimates of the discount rate r and expected rental growth rate g. Needless

to say, it is important to recognize these, and also to look out for future research

to help address these problems.

Notes

1. The shorter lease structure is prevalent within Europe (Adair et al., 1994). In a sample of

7,000 US office leases that were brokered in 1989 by CB Commercial, it is found that the

mean lease length is five years, but no leases are longer than 12 years (DiPasquale and

Wheaton, 1996). In the UK, the common lease term is five to ten years. The Asia-Pacific

markets appear to have the shortest leases. In Hong Kong’s office property, the market

displays lease terms of three to five years. In Japan, Singapore, Indonesia, Malaysia and

Thailand, leases are commonly for two to three years and in China, Taiwan and Korea one

to two years (Hillier Parker, 1994).

2. A lease is defined as a contractual arrangement for trading the rights to temporary use of

an object, but not the rights to all possible future uses.

3. The first lease term takes place during the period [L + F, L + N]. The initial lag vacancy

and rent-free period for the second lease term is also L and F respectively. It follows that

the second lease term takes place during the period [(N + L) + L + F, (N + L) + L + M] =

[N + 2L + F, N + M + 2L].

4. In general, the discount rate r equals real return plus inflation plus risk premium.

5. With free access to information, landlords continually act to acquire information on

market conditions. In imperfectly competitive markets, prices do not fully adjust to all

potentially available information. Landlords possessing market power may choose to set

rental rates which are either biased or not adjusted to all available information so as to

distort their information content (Andersen and Hviid, 1994). For instance, during

recessionary times, a tenant lease may not be signed if the rental rate is depressed.

6. In theory, inflation-indexed rents can transfer the risk of inflation from landlords to

tenants, but it is impractical in reality because rents only adjust in the new and vacant

office market, but do not adjust in the occupied market.

7. For instance, a six-year term with a rent review after the third year.

References

Adair, A.S., Berry, J.N. and McGreal, W.S. (1994), “Investment decision making: a behavioral

perspective”, Journal of Property Finance, Vol. 5, pp. 32-42.

Andersen, T.M. and Hviid, M. (1994), “Acquisition and dissemination of information in

imperfectly competitive markets”, Economic Inquiry, Vol. 32, pp. 498-510.

Benjamin, J.D., Torre, C.D.L. and Musumeci, J. (1995), “Controlling the incentive problems in real

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cycles”, The Journal of Real Estate Research, Vol. 9, pp. 455-85.

Brown, G.R. (1995), “Estimating effective rents”, Journal of Property Finance, Vol. 6, pp. 33-42. Academic papers:

Crosby, N. and Murdoch, S. (1994), “Capital valuation implications of rent-free periods”, Journal of

Property Valuation & Investment, Vol. 12, pp. 51-64.

Lag vacancy

DiPasquale, D. and Wheaton, W.C. (1996), Urban Economics and Real Estate Markets, Prentice-

Hall, Englewood Cliffs, NJ.

Dreyer, B.J. and Mathieson, K. (1995), “Ensuring consistency in the estimation of vacancy rates”,

The Appraisal Journal, April, pp. 209-12.

Fiedler, L.E. and Schweitzer, J.P. (1995), “Inflation and the intrinsic value DCF model”, Real Estate

87

Review, Vol. 24, pp. 5-15.

Flath, D. (1980), “The economics of short-term leasing”, Economic Inquiry, Vol. 18, pp. 247-59.

Hayman, A. and Ulrich, P.J. (1995), “Strategies for negotiating leases in transitional real estate

market”, Real Estate Finance Journal, Vol. 11, pp. 59-63.

Hillier Parker (1994), International Property Bulletin, Hillier Parker, London.

Hubert, F. (1995), “Contracting with costly tenants”, Regional Science and Urban Economics, Vol.

25, pp. 631-54.

Ibbotson, R. and Siegel, L. (1984), “Real estate returns: a comparison with other investments”,

AREUEA Journal, Vol. 12, pp. 219-42.

Jefferies, R. (1994), “Lease incentives and effective rents: a decapitalisation model”, Journal of

Property Valuation & Investment, Vol. 12, pp. 21-42.

Murdoch, G. (1994), “Property leases with staircased rents, some specialist market applications”,

Journal of Property Finance, Vol. 5, pp. 33-40.

Murtaugh, C.D. and Daspin, D.A. (1994), “Negotiating office lease operating cost pass-throughs”,

Real Estate Review, Vol. 23, pp. 63-4.

Peto, R., French, N. and Bowman, G. (1996), “Price and worth, developments in valuation

methodology”, Journal of Property Valuation & Investment, Vol. 14, pp. 79-100.

Rowland, P. (1996a), “Comparing net with gross rents”, Journal of Property Valuation &

Investment, Vol. 14, pp. 20-32.

Rowland, P. (1996b), “Modelling the allocation of lease responsibilities”, paper presented to the

AREUEA International Real Estate Conference, Orlando, Florida, May.

Further reading

Smith, P.F. (1995), “16th Annual Rent Review Conference revisited – Part I”, Rent Review & Lease

Renewal, Vol. 15, pp. 499-508.

(A1a)

implies

(A1b)

(A1c)

.

JPIF where N > F > 0 and r > 0.

17,1 Appendix 2. Derivation of optimal lease term

(A2a)

88 implies

(A2b)

(A2c)

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