 |
| The Pricing of Embedded Options in Real
Estate Lease Contracts Author: Gerald Buetow and Joseph Albert Start Page: 253 Abstract: Leases and rental
agreements often have options attached or embedded in them. These options sometimes depend
on a number of economic variables such as the consumer price index (CPI), a real estate
index and/or the value of real estate underlying the agreement. The evaluation of these
options often involves the solution or approximation to a partial differential equation
(PDE). This study analyzes the appropriate PDEs which model the situation where the lessee
is granted an option to either purchase the property or to renew the lease at a price
(rent) indexed to the CPI or some other readily measured economic variable. The PDEs that
result from the usual contingent claim asset-pricing framework are derived and numerically
solved using the finite difference method with absorbing boundaries. The value of an
embedded option to renew a five year lease on class A office space in each of the
ternty-five markets for which the National Real Estate Index reports quarterly rental data
is estimated. An evaluation of the model’s "Greeks" confirm that the model
conforms to financial intuition which provides support for the accuracy of the estimates. |
