Lag vacancy, effective rents and optimal lease term

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 lease. If the landlord is averse to risk, he can sacrifice some expected rental rates for a reduction in vacancy risk in rental renegotiation. It appears that shorter Journal of Property Investment & Finance, Vol. 17 No. 1, 1999, pp. 75-88. © MCB University Press, 1463-578X Received 20 July 1998 The research register for this journal is available at http://www2.mcb.co.uk/mcbrr/jpif.asp The current issue and full text archive of this journal is available at http://www.emerald-library.com