Cancellation Strategies in Commercial Real Estate Leasing
Mooradian, Robert M., Yang, Shiawee X., Real Estate Economics
Robert M. Mooradian [*]
Shiawee X. Yang [*]
In a contractionary corporate environment, lease cancellation strategy becomes an important component of corporate real estate leasing decisions. This paper presents a leasing model in which less well-informed lessors offer leases with alternative lease cancellation options. The model demonstrates that a tenant's choice of cancellation option reveals his private information with respect to the likelihood of option exercise. Tenants who select a lease with a downsizing option are more likely to exercise the option. Given the higher likelihood of option exercise, the model suggests that the downsizing option will be priced higher. We examine a sample of 311 leases, and consistent with the model's prediction, we find that on average leases with a downsizing option have significantly higher contract rent. However, termination and sublet options are not associated with higher rent. The evidence suggests that market uncertainty, private information and adverse selection affect the pricing of alternative cancellatio n options and the choice of cancellation option.
Traditionally a corporate tenant with excess real property such as office space has had two possible courses of action, lease termination and subleasing. However, lease cancellation has become more complex than the conventional cancellation of the entire leased space. Many firms seek to reduce the amount of leased space rather than cancel the entire leased space. Accordingly, with increasing frequency corporate leases contain clauses permitting downsizing, i.e., leases include the option for the tenant to cancel a portion of the leased space.
This paper provides both theoretical and empirical analyses of the valuation of leases with cancellation options. The three potential courses of action for a tenant faced with the need to reduce the contracted space are subleasing, cancellation of the entire lease and downsizing. First, subleasing permits the transfer of the partial right of use to another lessee. However, in an economic downturn subleasing is likely to be unattractive to a tenant, who is less likely to be able to locate a sublessee. Second, the lessee can utilize the cancellation clause in the lease and then negotiate a new lease for a smaller space. If the real estate market is very weak, the lessee may be able to renegotiate on terms more favorable to her. Finally, a downsizing clause permits the tenant to return the unwanted fractional space to the lessor regardless of the market conditions.
In the model presented in this paper, landlords offer a menu of contracts containing the cancellation-related clauses such that the landlord is indifferent to the tenants' choice of contract. Landlords design contracts such that through the tenants' contract selection, landlords can infer the tenants' private information with respect to the probability of cancellation-related option exercise. In particular, landlords infer that tenants who select a lease containing a downsizing clause have a higher probability of option exercise.
The data we use to test the model are drawn from a sample of leases from the early 1990s, a period of weak real estate markets where a landlord is more likely to experience considerable losses when having to locate a new tenant following a tenant's decision to exercise a cancellation-related option. We empirically analyze the use of the three forms of options for a sample of 311 commercial leases of a large public company that is a lessee of a large amount of real estate across the U.S. The rent increments and possible penalties associated with downsizing, cancellation and subleasing clauses are compared. We find that leases containing downsizing clauses have significantly higher contract rent (controlling for the size of the leased space) than leases without any of the three cancellation-related clauses. Leases with only a downsizing clause have a monthly rent premium on average of $7,600 per property (controlling for the size of the rented space). …