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Journal of Property Valuation and Investment
The valuation of upwards- only rent reviews: an option pricing model Charles Ward Nick French

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Charles Ward Nick French, (1997),"The valuation of upwards- only rent reviews: an option pricing model", Journal of Property Valuation and Investment, Vol. 15 Iss 2 pp. 171 - 182 Permanent link to this document:

http://dx.doi.org/10.1108/14635789710166376
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Charles Ward, Patric H. Hendershott, Nick French, (1998),"Pricing upwards-only rent review clauses: An international perspective", Journal of Property Valuation and Investment, Vol. 16 Iss 5 pp. 447-454 http:// dx.doi.org/10.1108/14635789810237556

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ACADEMIC PAPERS

The valuation of upwardsonly rent reviews: an option
pricing model

The valuation of
upwards-only
rent reviews
171
Received September 1996

Downloaded by VIT UNIVERSITY At 01:25 10 January 2015 (PT)

Charles Ward and Nick French
Introduction
The upwards-only rent review is a characteristic feature of the institutional property lease in the UK. It has been subject to increased attention by investors and regulators in the 1990s. In particular the Department of the Environment issued a consultation paper asking for comments on proposed legislation which sought to make upwards-only rent reviews illegal. Among the responding papers (see Baum et al., 1993, 1995; British Property Federation, 1993; Investment Property Forum, 1993; RICS, 1993; Stoy Hayward, 1993), arguments were put forward that suggested that capital values would fall and rents would rise as a result of the proposed legislation. However, the extent of the change differed depending on the attitude of the respondents to the issue and the method of valuation used. This paper attempts to apply a method based on market pricing which enables consistent valuations of different investment opportunities to be compared in a rigorous yet consistent approach. In earlier papers, French and Ward (1995, 1996) have used an arbitrage approach to value a reversionary property. They argued that the arbitrage approach lent itself to more complicated analyses and this paper uses the approach to value the difference between a lease in which the rents are reviewed upwards-only and that in which rents can be reviewed upwards or downwards. This paper starts by applying the arbitrage approach to a simple lease in which rent may take only two values. This simple approach is well established in the finance literature when analysing options and the valuation of the upwardsonly lease may be seen as a multi-option contract. Review of arbitrage valuation

For the sake of simplicity, it is assumed initially that the first example is of a lease for which rents may be revised upwards or downwards. This startingpoint then allows us to estimate the premium which investors would value the option to switch to upwards-only reviews. Of course, the process can then be reversed and the discount estimated which investors might accept to switch from the observed usual upwards-only reviews to a lease in which rent might be revised upwards or downwards.

The starting-point is the example contained in French and Ward (1995) of a fully let freehold on a lease of 25 years with five-year reviews. The conventional

Journal of Property Valuation &
Investment, Vol. 15 No. 2, 1997,
pp. 171-182. © MCB University
Press, 0960-2712

JPVI
15,2

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172

valuation (at an all-risk yield of 8 per cent and full rental value (FRV) of £100,000) is £1.25 million (see Table I).
The arbitrage solution may be expressed in three different formats. The first uses only the all-risk yield and the low-risk yield (Rf) observed in the money market as applying to short-term corporate bonds (where the yield appropriately reflects the security of the tenant’s covenant; see equation (1)). This formula is useful when we need to value components of the freehold; for example, the value of the first 15 years of the freehold can be estimated by substituting m = 15, n = 5 in the formula:

–n )
(1)
Vm,n = Vfh (1 – [1 – ynYP(n,Rf)] m
where
Vm,n = Value of terminable freehold, m years, with reviews every n years Vfh = Value of freehold (= Rent0/yn)
yn = All risk yield
YP (n, Rf ) = Years purchase for n years at the low risk rate Rf As shown in French and Ward (1995), the arbitrage valuation can also be expressed in the form shown in Table II, in which the deferred capital yield (DCY) is used to discount the reversionary capital value back to a present value figure.

The second arbitrage approach differs from the first only by explicitly including the rental growth. Consistent valuations will arise if the DCY rate is converted into the capital yield (CY) by increasing the DCY in direct proportion to the rental growth rate according to the relationship shown in equation (2): (1 + DCY) × (1 + rental growth) = 1 + CY

(2)
Given a rental growth rate of 4.63 per cent and the DCY of 7.494 per cent, the capital yield can be found to be 12.47 per cent and this gives the valuation found in Table III.

Table I.
Conventional valuation

Rent
Years purchase (perp @ 8%)
Valuation

£100,000...

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