Flexibility and Tenant Mix in Real Estate Projects

This paper presents a model in which owners choose the optimal mix of tenants. Tenant types are broadly defined to include not only the standard distinctions (office, retail, industrial, residential), but also more subtle distinctions such as the nature of business (store type in shopping mall), preferences (high-quality versus no-frills), or degree of credit risk. There are three key features of the model. First, relative rent levels for different tenant types vary stochastically over time. Second, tenant demands for space are interrelated and may produce positive or negative externalities for other tenants. Third, altering the current mix results in the payment of adjustment costs. Using the methods of option pricing theory, the intertemporally optimal tenant mix policy is derived and analyzed. In particular, several factors are identified which impact the degree of landlord “cautiousness” in altering the current mix. Finally, the value of the optimal policy is decomposed into two forms of flexibility: dynamic flexibility emanating from the sequence of options to alter the mix in the future, and static flexibility resulting from choosing an initial optimally diversified “portfolio” of tenant types.