PERCENTAGE LEASE AGREEMENTS - A REAL OPTIONS APPROACH

Abstract

The growing prevalence of percentage lease agreements (PLAs) in Singapore in the retail leasing market calls for better valuation of such agreements. In order to accommodate such agreements, an objective and comprehensive valuation framework must be developed, of which the option pricing approach appears to be the best alternative to the present methodology. The objective of the research is to determine the value of the default option (a put option) a PLA offers to the tenant using the option pricing theory. The default option is also examined on its susceptibility to changes in percentage turnover rates, interest rate volatility, relocation costs, market volatility and retail trade volatility. Finally, a proposal for an option pricing valuation framework whereby different PLAs can be evaluated would be made. The right to default is evaluated using the simplest binomial option pricing method. It is found that the option premium shows a positive relationship with percentage turnover rates, retail trade volatility and market volatility while sharing a negative relationship with interest rate volatility and relocation costs. Although inexact, the results would prove to be useful to landlords and tenants in determining the true worth of the retail lease. The theoretical and practical applications of this study have given rise to the realistic possibility of landlord and tenant working together to achieve greater profits in what used to be essentially a zero sum game.