May 2004

Take the Guesswork Out of Pricing Leases

The U.S. real estate market is estimated to be worth $5 trillion—more than the bond market—yet for most commercial landlords and tenants, figuring out the optimal terms and rates of leasing contracts is a matter of pure guesswork, says a Business School finance professor. The problem has become a critical one, particularly in markets such as San Francisco and Silicon Valley, where commercial rents have dropped 50 percent or more in recent years.

Professor Steven Grenadier has created the first model for pricing leases that takes into account real-life factors such as competition among builders and the uncertainty of demand for rental space. His model is a step toward helping any smart developer know what kind of rent he or she should be charging on leases with a host of complex terms—and what any savvy tenant should be willing to pay. It also can serve as a fairly accurate predictor of future rental prices in a specific market.

"Rent is often the second largest expense for companies after payroll," Grenadier says. "Yet, typically, when I ask renters whether they'd be willing to pay a lower rent in exchange for signing, say, a three-year lease instead of a five-year lease, they can't figure out what the ideal rent would be. Or, when I ask building owners how much higher a rent should be when they negotiate a lease with the right to renew, they say they're not sure. My model theoretically allows corporate tenants and landlords to figure out such things."

In a recent research paper, "An Equilibrium Analysis of Real Estate Leases," Grenadier demonstrates that the seemingly complex world of real estate renting—which involves contractual arrangements such as leasing with an option to buy, pre-leasing, cancellation clauses, and concessions—can be broken down into the fundamental building blocks of finance. "For example, I show that pre-leasing—leasing to rent at a future time—is analogous in finance to a forward contract in which you, say, set a price today for oil that you will buy a year from now," he explains. "Or, I show that a 10-year lease with an option to cancel after 5 years is like combining a put option with a stock purchase enabling you to sell the stock at a fixed price in the future, should the stock price fall."

Describing leases in such terms allows Grenadier to apply financial (or "real") options analysis to the question of leasing values. He simultaneously throws game theoretical analysis into the equation, which allows him to take into account factors that earlier theoretical approaches have not considered, such as the impact of competitive real estate development and the demand for rental space. The result is a quantitative model that can spit out optimal rental figures and lease terms under a variety of realistic leasing scenarios. "The model can show, for example, that renting at $20 a square foot along with an option to purchase the building at the end of the lease might be the equivalent of, say, renting at $17.50 a square foot with no such option," Grenadier says.

Ideally, the model can also be used to predict whether the future of a given commercial rental market will be bright or dim. An analysis that showed the majority of current leases are longer term and priced above short-term rents, for example, would indicate an expectation that rents will be even higher in the future—and tenants' corresponding wish to lock in at a favorable rate now. Conversely, an analysis showing a plethora of long-term leases below short-term rents would indicate an expectation of falling rents—and landlords' desire to lock in before prices plummet too far.

New research from UCLA has empirically shown that Grenadier's model more adequately reflects the movement of real estate markets than previous frameworks. Still, admits Grenadier, such a model would be difficult to implement as currently conceived. "It's hard for companies to get the necessary data on current lease values and trends, and most of the people who handle the contracts are lawyers who may not be terribly comfortable with mathematics," he says.

Creating a more user-friendly tool for managers may well be a promising avenue for future research. "A good analytic model will be a powerful tool for conducing lease negotiations," Grenadier says. "Negotiations can break down on the issue of rent, but if you can vary the terms, give more concessions, or provide an option to buy the building, you have extra leverage for working out a deal. The side that knows what the optimal terms should be will have a decided advantage."

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