Pricing short leases and break clauses using simulation methodology

This paper examines the changes in the length of commercial property leases over the last decade and presents an analysis of the consequent investment and occupational pricing implications for commercial property investments. It is argued that the pricing implications of a short lease to an investor are contingent upon the expected costs of the letting termination to the investor, the probability that the letting will be terminated and the volatility of rental values. The paper examines the key factors influencing these variables and presents a framework for incorporating their effects into pricing models. Approaches to their valuation derived from option pricing are critically assessed. Simulation methododology is applied to the rental and capital valuations of short leases and properties with break clauses. It is concluded that in addition to the rigour of its internal logic, the success of any methodology is predicated upon the accuracy of the inputs.