1. The Value of Break-options José Antonio Roodhof (Amsterdam School of Real Estate) & Ronald Huisman (Erasmus School of Economics)

2. Research Work in progress Model is tested in practice –However, this was not the purpose of the research Presentation is about pricing flexibility, the break-option is an example

3. Motivation In The Netherlands: Leases are becoming shorter Also; more flexible Possibility to change rented surface Flexible lease terms Break-options

4. Flexibility in leases For the lessee Advantage Less risk Responsive to change For the lessor Disadvantage More risk Uncertainty in future cash flow

5. Flexibility in leases From perspective of lessee: Lessee is willing to pay for the given flexibility From perspective of lessor: Lessor must be compensated for the exposed risk But: How much?

6. Value of the Break-option An upfront payment is unusual (in NL) A higher rent is accepted a risk premium as a compensation But: How much?

7. Value of the Break-option The concept of option-value in real estate is difficult We do not want to know the value of the option. –No financial product But what premium is rational for giving the option away?

8. Value of the Break-option Assumptions A standard lease of five year without notice periods and renewal options v/s The standard lease plus the option to terminate the lease at the end of year 3 or at the end of year 4 with a notice of 1 month (the flexible lease)

9. Value of the Break-option Furthermore, we assume The lessor is indifferent whether he offers the standard lease or the flexible lease with risk premium and break-option when the value of both alternatives is equal We apply the ‘real option theory’ Binomial tree

10. Value of the Break-option Value of the flexible lease Is lower than standard lease without risk premium Is equal as standard lease with risk premium

11. Value of the Break-option Flexible lease consists of two components –First component: The standard lease with the risk premium on top of the rent Value = V s (S+P) –Second component: The option to terminate the lease prematurely Value = V p (S+P) Value of the flexible lease = V s (S+P) - V p (S+P) The value of the first component minus the option value

12. Value of the Break-option The lessor is indifferent if: V s (S) = V s (S+P) - V p (S+P) But: how much is P? Which value of P makes the lessor indifferent?

13. Value of the Break-option The formula in our research shows that the lessor is indifferent whether he offers the standard lease or the flexible lease (with premium and option) if the value of the option is equal to the value of the revenues from the premia

14. Value of the Break-option A method to value ‘P’ We us the ‘real’ option theory Binomial tree

15. Value of the Break-option Looking for the value of ´P´ in such a way that the net present value of the premia of five year is equal to the value of the break-options Option valuation programmed in VBA, Excel Solver to reach to the optimal premium

16. Value of the Break-option Parameters –Discount rate –Volatility –Possibility Risk-neutral

17. Value of the Break-option Results –Rent:€175 –Discount rate3% –Volatility17.04% –Optimal premium€6.96 –Premium as %3.97% –Rent incl. premium€188.56

18. Value of the Break-option Survey among senior appraisers –Rent:€175 –Discount rate3% –Volatility19.94% –Optimal premium€8.75 –Premium as %5% –Rent incl. premium€182.75

19. Value of the Break-option Small difference between model and survey Model depends on a correct determination of the volatility of a single object Motivation to excercise break-option in this model is financial gain or loss Use in practice? Further research on volatility in real estate