An Empirical Test of a Contingent Claims Lease Valuation Model∗

Despite the importance of leases in the US economy, and the existence of several theoretical lease pricing models, there has been little systematic attempt to estimate these models. This paper proposes a simple no-arbitrage based lease pricing model, and estimates it using a large proprietary data set of leases on several property types. We also define a new measure, the Option-Adjusted Lease Spread, or OALS (analogous to an option’s implied volatility, or a mortgage-backed security’s Option-Adjusted Spread), that allows us to compare leases with different maturities and contract terms on a consistent basis. We find sizeable pricing errors that cannot be explained using interest rates, lease maturity, or information on the options embedded in the contracts. This suggests either that there are significant mispricings in the market for real estate leases, or that lease terms depend heavily on unobservable, property-specific characteristics. ∗The authors gratefully acknowledge helpful comments and suggestions from Monika Piazzesi, Sheridan Titman, Stathis Tompaidis, and participants at the January 2000 AREUEA meeting, the 2002 NBER Summer Institute and the 2002 Vail Real Estate Conference. We are grateful for financial support from the Fisher Center for Real Estate and Urban Economics. Please address correspondence to (Stanton): Haas School of Business, University of California at Berkeley, Berkeley, CA 94720. Phone: (510) 642-7382. Fax: (510) 643-1412. Email: [email protected]. (Wallace): Haas School of Business, University of California at Berkeley, Berkeley, CA 94720. Phone: (510) 642-4732. Fax: (510) 643-1412. Email: [email protected].