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The Journal of Real Estate Finance and Economics

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01-05-2016

The Rent Term Premium for Cancellable Leases

Authors: Jiro Yoshida, Miki Seko, Kazuto Sumita

Published in: The Journal of Real Estate Finance and Economics | Issue 4/2016

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Abstract

This study analyzes the rent term premium for leases that can be cancelled by the lessee. We model the lessor’s trade-off between leasing costs and the cost of cancellation options based on the recognition that many leases are cancellable by lessees, and lease markets involve significant transaction costs. We demonstrate that, regardless of the expected future rents, the rent term structure is upward-sloping when there is no leasing cost but U-shaped when the lessor faces moderate leasing costs. Residential leases in Japan, which are all cancellable by tenants, exhibit the term structure that is consistent with our calibrated model.

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Source: The Real Estate Roundtable, 2011 Annual Report. Available at http://www.rer.org.

Source: The Equipment Leasing and Finance Foundation, Economic Impacts of the Proposed Changes to Lease Accounting Standards, December 12, 2011. Available at http://www.leasefoundation.org.

This type of lease contract was prevalent before 1941 but eliminated to prevent landlords from evicting incumbent tenants and circumventing rent control during World War II (Survey of New Form of Residence Associated with Fixed-Term Lease Contracts, Housing Research and Advancement Foundation of Japan, March 2015).

This requirement is specified by Article 28 of the Tenure Law, which is known as “Shakuchi-Shakka-Hou” in Japan.

See Iwata (2002) and Seko and Sumita (2007) for a discussion of the asymmetric nature of lease restrictions and the effects of the role of these asymmetries as a form of rent control.

Ministry of Land, Infrastructure, Transport, and Tourism, 2013FY Housing Market Survey (Jutaku Shijo Doko Chosa).

The stochastic discount factor is derived from the first-order condition for the lessor’s utility maximization problem given the lessor’s wealth portfolio and consumption stream.

Ambrose et al. (2002) study the opposite type of leases; in other words, leases with rents that adjust only in the upward direction.

The lessor’s use of alternative lease types does not change our proof because lease values for alternative leases are equalized at any time under the lessor’s consistent pricing condition.

The rent term premium is also affected by the expected net rent gap prior to the final period. We take into account the total rent gap in our numerical exercise.

We use lease contracts that are shorter than or equal to five years because the number of leases longer than five years is small and their tenant characteristics are significantly different from the average characteristics.

In Appendix D, we present the result of additional tests by probit regressions.

This empirical strategy is equivalent to pooling both types of leases and including interaction terms with a fixed-lease dummy by treating general leases as a reference group.

The average of the 2003 and 2008 national vacancy rates for rental housing is 19 %.

The estimated term structures exhibit the same shapes based on Models (b), (c), or (d).

The mean values are 16.4 and 15.1 years for building age, 9.5 and 9.8 min for the time to the nearest station in low- and high-vacancy areas, respectively.

To compute the market rent for the remaining term, we use a homogeneity property of the model. Because the rent risk, renewal costs, and risk-adjustments are all multiplicative, the ratio of the \( \left(T-t\right) \) year lease rate to the short-term rate at time t equals that ratio at time zero. Thus, \( {\hat{R}}_t^{T-t}={\hat{R}}_0^{T-t}\times {R}_t^1/{R}_0^1 \) \( . \)

We implicitly assume that the landlord inelastically supplies an existing rental unit and thus bears all costs associated with market frictions. This assumption simplifies computations because the lessee’s cancellation decisions are not affected by these costs.

The lessor’s risk aversion and the riskiness of short-term rents represented by a negative covariance with the discount factor alter the probability mass function under measure Q. Specifically, when short-term lease rates are negatively correlated with the discount factor, a larger probability mass is assigned to the state of a low rent as the risk aversion becomes larger. Then, the lower expected value under measure Q represents the certainty-equivalent value.

Source: Recruit Residential Price Index, January 14, 2013.

Available at http://www.jresearch.net/house/jresearch/rrpi/index.html.

Rotten structures are excluded in this calculation.

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Title: The Rent Term Premium for Cancellable Leases
Authors: Jiro Yoshida
Miki Seko
Kazuto Sumita
Publication date: 01-05-2016
Publisher: Springer US
Published in: The Journal of Real Estate Finance and Economics / Issue 4/2016
Print ISSN: 0895-5638
Electronic ISSN: 1573-045X
DOI: https://doi.org/10.1007/s11146-015-9528-x

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