Valuation of Default Risks in Percentage Leases in Option Pricing Framework

Percentage lease agreements (PLAs) contain lease clauses with payments of a flat base rent plus a variable rent, which is pegged to the sale turnovers. PLAs have been widely regarded as an important mechanism to achieve risk sharing, tenant mix and also rent discriminating objectives in shopping center management. There are no studies that examine the issue of default risks in the PLAs . In the earlier literature on leasing risks, Grenadier (1996) models the default timing as an exogenous stochastic variable in his leasing risk model, and he showed how the default risk should be reflected in the equilibrium lease rate to compensate the landlord for the leasing risks. Sing and Tang (2002) then extended the model to examining the default options from the perspective of a tenant. This paper develops a multi-period binomial tree option-pricing model to explicitly evaluate the default options in the PLA framework. In the absence of lease’s pretermination penalties, the tenants are deemed to possess an implicit call option, upon which if exercised gives them a right to Ã?breakó a lease and move to alternative premises at a lower fixed prevailing market rent. Based on a hypothetical retail PLA lease with various base case parameter assumptions, the value of the tenant’s default option was estimated at 1.08% for a 3-year term. When uncertainties in both sale turnovers and relocation costs are simulated using selected random probability processes, the expected option premium increases by 0.18% to 1.26%. A positive relationship between the option premium and rental volatility was observed, which is consistent with the standard real options theory. The percentage used to set the base rent and the overage rate are lease-specific factors that were found to have positive effects on option premium, whereas the option premiums decline when the relocation costs and the sale breakpoint increase.