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ACADEMIC PAPERS Academic papers:


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

Keywords Lease, Rent, Risk


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

Effective Rent/Face Rent (%)


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%

the expected lag vacancy L can be regarded as a probability density function


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

g (per cent) r = 5 per cent r = 10 per cent r = 15 per cent

L = 3, F = 2 7.7 9.5 11.4


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.

Risk factors in choosing lease term


(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.

(c) Tenancy default


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.

(d) Long-term relationship


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.

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

Appendix 1. Derivation of effective rents

(A1a)

implies

(A1b)

Re-arranging this yields

(A1c)
.
JPIF where N > F > 0 and r > 0.
17,1 Appendix 2. Derivation of optimal lease term

(A2a)

88 implies

(A2b)

Simplifying this expression gives,


(A2c)

Similarly, M can be expressed in terms of L; F; g and r.