Exploitation, Expropriation and Capital Assets: The Economics of Commerical Real Estate Leases

Article excerpt

Abstract

This study reviews commercial real estate leases as one transaction form to finance corporate capital assets. Credit risk is common to leases and debt as substitute transactions; but the two credit forms generate different transaction costs and agency conflicts, and thus differential pricing. Causal relationships resulting in explicit options in leases reflect complex agency considerations, which complicate the application of current option pricing principles to value the options. In general, it seems as if lease pricing phenomena are poorly researched. This article aims to identify where more narrowly demarcated research could assist in unraveling lease pricing behavior.

There is little doubt that the priority in real estate investment research over the last three decades has been to progress the understanding of the behavior of real estate as an asset class within developments in capital market theory. In all, the pursuit of this priority has indeed generated a large body of theoretical and empirical research that has achieved this aim, notwithstanding the continuing data problems experienced by all seeking to unravel the fundamental questions related to real estate investment. Despite the progress in capital market theory-inspired research into real estate, research into real estate economics and finance at the asset level has been neglected, and in effect this neglect may have delayed the introduction of the same capital market theory into real estate investment analysis at the asset level-where it is equally relevant. One such area that has been overlooked is the nature of commercial real estate leases as financial investments. Another neglected area is the contribution of a portfolio of leases to total returns and the risk of an asset over a holding period. For example, when commercial real estate investments are viewed as being a two-part portfolio, namely the lease portfolio and the asset residual, it is clear that leases pose a problem of valuation, portfolio construction and portfolio management, similar to a portfolio of loan contracts to a bank. It may thus seem that an analysis of the underlying financial contract-the leases-in a more disaggregated and theoretically rigorous manner has been neglected, particularly when compared to the body of work on debt contracts. Indeed, Sirmans and Miller (1997) state that although real estate investment analysis is fundamentally about lease valuation, much less is understood about leases as financial instruments, for example, than about mortgages.

A range of practical benefits may flow from concerted and systematic research into leases. Better financial data on term and risk structure of lease returns could allow better structuring of target lease portfolios for investors in single multi-tenanted and/ or portfolios of multi-tenanted properties, and facilitate the application of risk management practices used elsewhere in the financial sector to commercial real estate investment. For example, Sirmans and Miller (1997) point out that institutional investors with access to detailed lease-by-lease data could develop a better profile of the riskiness of a lease portfolio and the risk added by major new leases or various types of lease clauses under consideration (such as options). Furthermore, identification and isolation of the influence of leases on asset price behavior may allow fine demarcation of research to unravel the dynamics of commercial real estate asset price movements and thus risks to lenders' collateral. Often-used proxies for riskiness of rental income in the analysis of real estate investments, such as comparable bond ratings for lessee quality, may also be replaced with information that reflects economic and financial risks that are specific to leases rather than to assume that leases and debt contracts may be treated as substitutes. There may also be potential improvements in real estate investment performance evaluation from a better understanding of lease portfolio structures as suggested by Turner and Thomas (2000). …