The Impact of Lease Structures on the Optimal Holding Period for a Commercial Real Estate Portfolio

Purpose The purpose of this paper is to exhibit the impacts of lease duration and lease break options on the optimal holding period for a real estate asset or portfolio. Methodology/approach We use a Monte Carlo simulation framework to simulate a real estate asset’s cash-flows in which lease structures (rent, indexation pattern, overall lease duration and break options) are explicitly taken into account. We assume that a tenant exercises his/her option to break a lease if the rent paid is higher than the market rental value of similar properties. We also model vacancy duration stochastically using Poisson’s law. Finally capital values and market rental values are simulated using specific stochastic processes, and are also assumed to be correlated. We derive the optimal holding period for the asset as the value that maximises its discounted value, which is the sum of the discounted free cash flows and the discounted terminal value. Findings We demonstrate that, consistent with existing capital markets literature and real estate business practice, break-options in leases can dramatically alter optimal holding periods for real estate assets and portfolios by extension. We show that, everything else being equal, shorter lease durations, higher market rental value volatility, increasing negative rental reversion, higher vacancy duration, more break options, all tend to decrease the optimal holding period of a real estate asset. The converse is also true. Practical implications Practitioners are offered insights as well as a practical methodology for determining the ex-ante optimal holding period for an asset or a portfolio based on a number of market and asset specific parameters including the lease structure. Originality/value The originality of the paper derives from taking an explicit modelling approach to lease duration and lease breaks as additional sources of asset specific risk alongside market risk. This is critical in real estate portfolio management because such specific risk is usually difficult to diversify.