THE OPTION TO DEFAULT IN COMMERCIAL OFFICE LEASES

Abstract

A tenant contracted to a lease agreement has an option to default on the agreement any time throughout the lease period. This option can be valuable if there is a possibility of market rent falling below the amount that the tenant is contracted to. If such a scenario occurs, the tenant can default on the existing lease agreement and sign up a new lease at another location at a lower rent. This study attempts to derive a model to estimate the value of the default option using the binomial-tree option pricing approach. A sensitivity analysis is conducted to determine how various factors, such as the size of leasable space, the contracted rent and relocation costs, can affect the option value. This allows the characteristics and type of tenants who are more likely to default to be determined. It was found that the value of default option is significant for tenants contracted to high rents in premium-grade office buildings, and those who are less conscious on fitting-out quality as their relocation costs will not be too high. The default option is not feasible for the majority of tenants, especially those contracted at lower rent, as relocation costs will diminish their potential saving. This insulates landlords from the risk of defaults during a market downturn. However, landlords should still take into account the value of the default option in the lease agreement, especially for tenants with a higher risk of default.