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The Journal of Real Estate Finance and Economics

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01-08-2016

The Economics of Commercial Real Estate Preleasing

Authors: Robert H. Edelstein, Peng Liu

Published in: The Journal of Real Estate Finance and Economics | Issue 2/2016

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Abstract

Preleasing of to-be-built commercial real estate space is a pervasive worldwide practice. Although such preleasing is an extensive and significant activity, it has not received adequate attention in the real estate economics and finance literature. Using an equilibrium micro-economic agency model, this paper examines the economics of commercial real estate preleasing. The equilibrium prelease contract rent is a function of several variables, including the expected spot market rent, financing benefits from preleasing, developer-lessor and tenant-lessee risk-hedging behavior, the interplay between lessor and lessee default options, and the market capitalization rate. Our paper demonstrates how the distribution of risk preferences for lessees (and lessors) generates separating market equilibrium for the prelease and spot lease. We also consider the impacts of developer default and the lessee cancellation clause on the prelease rent equilibrium.

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Our paper focuses on preleasing for to-be-built (new) commercial real estate projects. The analysis is applicable, with relatively simple modifications, to other commercial preleasing arrangements for existing properties as well as lease renewal options.

Although they are popular in retail development, prelease contracts for anchor tenants such as department stores frequently contain significant rent discounts because (1) the anchors bring positive externality to the shopping center and (2) anchor tenants simplify and enhance the renting of space to other tenants. For detailed review of the role of the anchor tenant in the retail real estate setting, please refer to Liu and Liu (2013).

Although CARA utility does not contain a wealth effect, the main insights for our analyses do not depend on the choice of the particular utility function. It can be shown that the same results obtain if we model the maximization of consumer surplus. Another form of utility function frequently used is Constant Relative Risk Aversion (CRRA), which engenders similar results.

The scale of the development is pre-determined.

The spot market rent is treated as an effective rent that takes vacancy into consideration.

If the quantities of production are allowed to vary, along with the scale of forward hedging, the results remain unchanged. as established by Feder et al. (1980), in the presence of the forward market a complete separation is maintained between the production decision and the hedging (forward-selling) decision. Edelstein et al. (2012) also find that pre-committed sales do not affect a developer’s production decision.

A commercial lease usually contains non-disturbance and lease assignment clauses, which require that tenants continue to occupy the building and pay the rents irrespective of changes in ownership.

Explicitly introducing lessee risk heterogeneity makes the scale of the market equilibrium demand for prelease contracts endogenous.

Assuming that the developer or the local real estate development authority has done a thorough feasibility analysis before the development permit was issued; we should not expect a sudden shift in space market demand.

For expositional simplicity, we assume that lessee transaction and search costs caused by the lessor default are nil and that there are no litigation actions.

There are certainly other reasons that a tenant does not honor the prelease contract such as tenant default or down-sizing, or alternative location choice, etc. On the other hand, there may some hidden costs of cancellation for the lessees. Therefore the proportional loss α should be interpreted as an effective economic threshold for exercising the cancellation clause.

We abstract from additional lessee search costs and lessor space marketing expenses.

Note that G is a function of γ. Therefore Eq. (25) is an implicit definition of γ.

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Title: The Economics of Commercial Real Estate Preleasing
Authors: Robert H. Edelstein
Peng Liu
Publication date: 01-08-2016
Publisher: Springer US
Published in: The Journal of Real Estate Finance and Economics / Issue 2/2016
Print ISSN: 0895-5638
Electronic ISSN: 1573-045X
DOI: https://doi.org/10.1007/s11146-015-9515-2

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