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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To cite this document:
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
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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

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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
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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 tenants 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

100,000.0
12.5
1,250,000.0

Table II.
Arbitrage valuation
(implicit growth)

Term rent
Years purchase (5 years, 10%)
Reversion
Years purchase (perp, 8%)
Property valuation (5 years, defined
capital yield (DCY))
Value

100,000.0
3.79
100,000.0
12.5
(DCY = 7.494%) = 0.6967

379,080.0

870,920.0
1,250,000.0

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Simple binomial model of upwards-only rent review

The valuation of
As stated above, it is assumed initially that the above valuations are for leases
upwards-only
which have up-or-down rent reviews. Let us consider the valuation of the
rent reviews
separate components of the lease for the first two terms, that is, for the first ten
years of the lease.
On arbitrage principles, the first five years can be valued either by equation
(1) or by using the low risk yield in the YP formula for the first five years. In the
173
latter case, the value of the first five years is Rent0 YP (5 years, 10 per cent) or
379,080. But using equation (1), the first two terms can also be valued by
substituting m = 10 in the formula. The value of the first ten years of the first
asset is therefore given by:
(3)
V10,5 = Vfh (1 (1 y5,YP(5Rf ))2) = 643,197
It has already been found that the value of the first five years is 379,080, so by
subtracting this from the value of the first ten years, the present value of the
second five-year term can be estimated to be 643,197 379,080 = 264,117.
This value can be derived by valuing the second five-year reversion at the allrisk yield deferred five years at the capital yield (see Table IV).
We assume that this is the price that this asset would realize if sold in the
money market and will label the value Valt=0 .
Let us now assume that the market rent at the end of the first review can
change either upwards by 20 per cent (120,000) or downwards by 15 per cent
(85,000). The respective probabilities of these events do not have to be
specified, but it should be remembered that the rent is revisable upwards or
downwards. How valuable would be the next five years rent at the beginning of
the second term? The answer would be either 120,000 YP (5, 10 per cent) or
85,000 YP (5, 10 per cent). This can be written in the form:
Valupt=5 = YP (5 years, 10%) 120,000 = 454,894

Term rent
Years purchase (5 years, 10%)
Reversion growth = 4.63%)
Years purchase (perp, 8%)
Property valuation (5 years,
capital yield (CY))
Value

Reversion rent
Years purchase (5 years, 10%)
Property valuation (5 years, CY)
Value of second term

100,000.0
3.79
125,411.0
12.5
(CY = 12.47%) = 0.55567

125,411.0
3.79
(CY = 12.47%) = 0.55567)
264,117

379,080.0

870,920.0
1,250,000.0

Table III.
Arbitrage valuation
(Explicit growth)

Table IV.
Arbitrage valuation
of second term

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174

Valdownt=5 = YP (5 years, 10%) 85,000 = 322,217

(4)
However, if we had an upwards-only rent review clause, we would in effect have
the option of giving up the present rent for five years in exchange for the new
rent for five years. In financial terms, we would recognize that the value of five
years at the old rent is effectively the exercise price for exercising the option.
The additional benefit can be expressed in the form
Valoptupt=5 = YP (5 years, 10%) Max(120,000 100,000 or 0) = 75,816
(5)
Valdownt=5 = YP (5 years, 10%) Max(85,000 100,000 or 0) = 0
In this expression, the term Max(120,000 100,000 or 0) is a short-hand version
of the statement that the investor can either take the difference between the new
rent (120,000) and the old (100,000) or suffer no penalty at all (0). In the latter
case, the rent remains unchanged at the level ruling before the review is
effected. As can be seen in the down instance, the option is worthless and the
investor will choose not to exercise it as the new rent (85,000) is less than the
old rent (100,000). These states are represented in Figure 1.

Figure 1.
Pay-offs in a two-state
world

Note that there are two assets and it is assumed that both assets can be bought
or sold in whole or in part. It is also assumed that either asset can be sold
short. This type of transaction is possible in many capital markets and
amounts to selling an asset (thereby receiving cash now) and buying it back
later (thereby paying out cash). If the price of the asset has fallen in the mean
time, obviously one has made a profit on the whole transaction.
In this case we are setting up two transactions. First we will buy one unit of
Asset 1. Second we will short sell some number (N) of Asset 2. We shall be
paying out cash for the first transaction but receiving cash for the second
transaction. When the transactions are complete we will then be paid off
(receiving money from the first and paying out money for the second). The payoffs of the combined portfolio will therefore either be:
State of world =

Up
454,894 75,816N
or
depending on whether the market rent rises or falls.

Down
322,217

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But in these pay-offs, N the number of assets sold short has not yet been The valuation of
specified. So N can be fixed to equalize the pay-offs in either state. It can be
upwards-only
seen that if N = 1.75 then, when the market rises, the pay-off will be 454,894
rent reviews
1.75 75,816 = 322,216, which is the same as the pay-off in the second state.
But if the pay-offs are the same in either state, it implies that we have
constructed a portfolio that has no risk (using risk in the sense of return
175
variability). If we have a portfolio that has no risk, we can discount it by using
the low-risk rate of interest. Since the cash flows are the same in either state,
the respective probabilities do not affect the value. The value of the portfolio
will therefore be
Value of Portfolio = 322,217/(1 + Rf )5
(6)
= 200,071
The portfolio costs us the value of the first asset less N times the value of the
second asset. The value of the first asset is Valt=0 = 264,117 but the value of
the second asset is not yet known. This can be solved by the following
equation:
264,117 1.75 Valoptt=0 = 200,071
(7)
so Valoptt=0 = 36,598
This is the premium on the upwards-only rent review lease for the second term.
In effect, the difference between an upwards-only review for years five to ten
and an up-or-down rent review has been valued. This estimate is derived using
prices/values that we could see in the market if the assets were traded. In fact
the only information that we needed to use that was not directly observable
was the extent of the movement in the rent at the end of the first term. We were
not required to forecast the likely rent. That would only have been required if
we had had to specify the probabilities of the likely rent changes.
Figure 1 in which both the numbers and formulae appear represents in
more general form what has been presented in numerical terms. To re-cap the
argument, first a portfolio with pay-offs in either state (market-up and marketdown) is specified.
Pay-offs are equal when:
N=

Valupt = 5 Valdownt = 5

(8 )

Valoptupt = 5 Valoptdownt = 5

But this expression can be simplified because all four terms contain YP (5, 10
per cent). Furthermore
Valupt=5/YP(5, 10 per cent) = 1.2 Rent0
while
Valdownt=5/YP(5, 10 per cent) = 0.85 Rent0
So if U. Rent0 for the first term and D.Rent0 for the second term is used, equation
(8) can be expressed in the form:

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176

N = Rent 0

UD
Cu Cd

where Cu = Max( U . Rent 0 Rent 0 , 0 )

and Cd = Max( D. Rent 0 Rent 0 , 0 )
The value of the option can, after some elementary algebra, be shown to be:
C0 =

Cu.q + Cd .(1 q )

(1 + R f )
1+ R f D
where q =
UD

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(9)

(10 )

In this form, the value of the option appears to be modelled as the present value
of the pay-offs to the option, each weighted by quasi-probabilities (q and 1 q).
These two terms are not true probabilities but they are always positive
numbers and sum to 1. As will be seen below, when the number of periods is
increased, they still appear and retain these properties.
Multi-period extension of the two-state model
The model as derived above is simple but can be made more practical by
extending the number of periods over which the price can move up or down.
The process will merely be shown diagrammatically for a further period before
referring to the seminal papers of Cox et al. (1979) and the Rendleman and
Bartter (1979) papers in which this approach was first derived.
The approach can be generalized by increasing the number of periods of
time over which the market rent can move (see Figure 2). As another period is
added, the number of final states increases. The valuation problem can be
solved in the diagram by solving period-by-period. With a computer, it can
simply be carried out on a spreadsheet. For the two-period case, the value of
the option is given by
C0 = Cuuq 2 + 2Cud q(1 q ) + Cdd (1 q ) 2 /(1 + rf ) 2
where Cuu = the pay-off to the option when the rent
has moved upwards in both periods

(11)

As can be seen, the quasi-probabilities still appear, albeit in a more complicated

form.
Cox et al. (1979) show that the multi-period solution approaches the Option
Pricing Model of Black and Scholes (1972). In their model, the model becomes
based on continuous time and instead of distinct outcomes (such as Cud) the
value is calculated on the basis of a continuous distribution; the terms U and D
disappear and are replaced by the standard deviation of the returns from the
underlying asset. In this application, the appropriate underlying asset is the

The valuation of
upwards-only
rent reviews

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177

Figure 2.
Multi-period two-state
model

annual market rent. Thus, the Black and Scholes model can be used to value the
option to review rents on an upwards-only basis.
Black and Scholes model of option pricing
The extension of the Binomial Option Pricing Model was derived from the
assumption of continuous trading and arbitrage activity in 1972 and it was only
later that its relationship with the Binomial Model was demonstrated. The
Option Pricing Model reflects something of the structure of the Binomial Model
in that it contains two parts, the first containing the current value of the
underlying asset multiplied by a number between 0 and 1. The second term
contains the exercise price, discounted back at the riskless rate of interest also
multiplied by a number between 0 and 1.
C = S . N ( d1 ) X . N ( d 2 )e rT
where N (.) = cumulative normal probability of a unit normal variable
d1 =

Loge ( S / X ) + ( r + o 2 / 2 )T
o T

d2
r
S
X
T

= d1 o T
= continuously compounded riskless rate of interest
= present value of underlying asset
= the value of the exercise price
= the time between the valuation of the option and the
date at which it can be exercised (5 years)

(12)

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178

If this formula is applied to the second term (years five to ten), the value of the
underlying asset at t = 0 has already been calculated to be 264,117, while the
exercise price was estimated to be the value of five years at the old rent (Rent0
.YP(5 years, Rf) or 379,079. If the volatility of rents is assumed to be 8.5 per
cent, the continuously compounded riskless return to be 9.53 per cent, d1 is
equal to 0.7 and d2 = 0.51. Looking up these values in normal probability tables
gives us the value of N(d1) and N(d2) respectively of 0.758 and 0.695. The option
value therefore is estimated by equation (12) to be 36,598. In this example, the
volatility has been chosen to produce an estimated value close to that in the
simple binomial model above and results in an estimated premium of just over
14 per cent on the up-or-down lease.
The value of the premium clearly depends on the volatility, but there is a
more significant extension that must be taken into account before it can be
applied to property leases and now the difficult task of implementing this model
in the real world can be considered.
Difficulties in applying the option pricing model to the 25-year
lease
In the previous section, an option analysis of the second term of a 25-year lease
was constructed. In effect, the value of constricting the rent review at the end of
the first term either to adjust to the new market rent or to remain at the rent
being paid for the first term was considered. But in the course of a 25-year lease
there will be rent reviews at five, ten, 15 and 20 years time. Thus at t = 5, there
are several possibilities that can effectively result from rent review. First, the
market rent may be lower than that already being received, so the rent remains
unchanged. (In option terminology, the investor does not exercise the option.)
Second, the market rent is higher and the rent is reviewed upwards and remains
at that level for the next five years (until t = 10, at which point it is again
increased). Third, the rent is reviewed upwards but remains at that level for ten
years (because it turns out that the market rent at t = 10 is lower than that
already agreed for the term beginning at t = 5). Fourth and fifth, the rent is
revised upwards and remains at the new level for 15 and 20 years respectively.
Thus it can be seen that the investor has several options and may hold them
simultaneously.
Even more complicated cases can arise. For example, the rent may not be
changed at t = 5 and t = 15 but may change at t = 10 and t = 20. Each of these
changes is effectively an option, but the options that might be exercised at a later
date have uncertain exercise prices because the level of rent that will be
operating in the period before the rent review is made is not known (for example,
if the rent review in the 15th year is considered, the level of rent that will have
been agreed will not be known, even if the rent had been raised at t = 10).
Uncertain exercise prices are known in the finance literature and models by
Fisher (1978) and Margrabe (1978) provide methods of valuing specific types of
these options. However, these approaches require the correlation between the
underlying asset and the option-asset to be assessed. It was impossible for the

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authors to derive the correlation analytically. In the absence of an analytical The valuation of
solution, three approaches could be used. First, simulation could be used to
upwards-only
provide approximate correlations. But, if this were adopted, an analysis might
rent reviews
as well have been carried out in which the options themselves were analysed by
simulation. Second, a Markov process analysis could be applied, which could
use assumptions about the distribution of the rent but would provide a point
179
estimate of the compound options embedded in the 25-year lease. This method
is the subject of another study (Rehman et al., 1995), so was not adopted here.
Finally, the expected rents at the time of the previous review could be used and
this is the method adopted in this paper. In so far as the exercise price could take
a range of values rather than the expected value used, there is some error
introduced into the analysis. But the value of the compound option is itself the
maximum of several mutually exclusive compound options. Bias is not
necessarily introduced by the adoption of a known exercise price in each
contributing option, so it is argued that this approach is a reasonable and
pragmatic solution to the problem.
Table V provides some indication of the different routes which, at the start of
the lease, are available to the investors (owners). Of course, once the lease is
operating, the investors cannot exercise all the options. For example, if the rent
is not revised upwards at year five, it cannot be adjusted from the market rent
of the fifth year to the market rent observed in the tenth year of the lease; it
could only be adjusted from the rent being initially set in the first year to the
market rent in year ten. So each row of the Table provides a mutually exclusive
opportunity for the investor as evaluated at the start of the lease.
In Table V, one can see that the first row implies that the investor would
exercise five-year options at five, ten, 15 and 20 years. This can be contrasted
with the sixth row which implies the investor will exercise a ten-year option at
year ten and a five-year option at year 20. To value these different combinations
is relatively simple since, at the beginning of the lease, the value is the
maximum value of any row combination. Some care has to be taken to specify
the underlying asset price and the exercise price. To give an example of the

Route 1
Route 2
Route 3
Route 4
Route 5
Route 6
Route 7
Route 8

t=5

t = 10

t = 15

t = 20

Table V.
Alternative points at
which rents can be
reviewed

JPVI
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180

calculation, the value of the underlying asset for the 15-year period beginning t
= 10 is derived, having exercised the five-year option at t = 5.
The underlying asset is the five-year term from t = 10 to t = 15. But this is
equal to the present value (at t = 0) of the 15-year term less the present value (at
t = 0) of the ten-year term. Equation (1) can be used to derive both these values.
The exercise price is the value of the asset that has to be given up. Since the fiveyear option has been exercised at t = 5, the rent passing is assumed to be the (t
= 0) full rental value compounded at the implied growth rate for five years. But
this could be operating for the whole of the later 15 years, so the exercise price
is FRV (1 + g)5 YP(Rf, 15 years). Similar calculations can be carried out for
the other options.

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Results of the analysis sensitivity to the parameters

Table VI presents the initial yields of upwards-only rent review leases against
variations in initial yields of up-or-down rent review and volatilities of rents. It
can be seen that, as expected, the yield is lower for the upwards-only lease (that
is the lease is more valuable). It will also be noted that the yields decrease as the
volatilities increase. This again is plausible because the restriction to review
upwards-only would come into play more frequently as rents become more
volatile.
An alternative demonstration of the effect is to plot the information as a
graph. In Figure 3, the percentage component of the upwards-only rent review
lease that is attributable to the options included is presented. The importance of
the upwards-only constraint is more obvious when presented in this form
because the difference is represented by the effect on the total value of the
property. Even with relatively low volatility such as 10 per cent, the upwardsonly effect accounts for 15-20 per cent of the value at yields of 7 per cent to 8 per

Table VI.
Initial yield of upwardsonly 25-year lease

Variations in up or
down rent review
(%)

5.0

7.5

Volatility of annual rents (%)

10.0
12.5
15.0
17.5
20.0

22.5

25.0

4.0
4.5
5.0
5.5
6.0
6.5
7.0
7.5
8.0
8.5
9.0

3.0
3.3
3.7
4.2
4.6
5.1
5.7
6.3
6.9
7.6
8.3

3.0
3.3
3.7
4.2
4.6
5.1
5.6
6.2
6.8
7.4
8.1

2.9
3.3
3.7
4.1
4.6
5.0
5.5
6.1
6.7
7.3
7.9

2.8
3.1
3.5
3.8
4.2
4.6
5.1
5.5
6.0
6.5
7.0

2.8
3.1
3.4
3.8
4.2
4.5
5.0
5.4
5.9
6.3
6.9

2.9
3.3
3.7
4.1
4.5
5.0
5.4
6.0
6.5
7.1
7.7

2.9
3.2
3.6
4.0
4.4
4.9
5.3
5.8
6.4
6.9
7.5

2.9
3.2
3.6
4.0
4.4
4.8
5.2
5.7
6.2
6.8
7.3

2.8
3.2
3.5
3.9
4.3
4.7
5.2
5.6
6.1
6.6
7.2

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cent. In periods of uncertainty when the volatility might be expected to be The valuation of
greater, the effect can amount to nearly 25 per cent of the value of the property.
upwards-only
Using the volatility of the Hillier-Parker Rent index, the volatility might be
rent reviews
reasonably estimated to be in the region of 10 per cent. From Figure 3 it can be
seen that, at a yield of 8 per cent, about 17 per cent of the value of an upwardsonly rent review reflects the upwards-only constraints. From Table V it can be
181
seen that, if the restraint were to be relaxed, the initial yield would be more than
9 per cent.

Figure 3.
Proportion of value
attributable to upwardsonly condition

Of course, as argued by Baum et al. (1995), there might be a redistribution of the

changes in value between the landlord and tenant. If, as a result of the lifting of
the upwards-only rent review restriction, the property becomes less valuable for
landlords/investors, it simultaneously becomes more valuable for tenants. From
the point of view of investors, new property would only come on to the market
if an adequate return was expected and, in the long run, investors would
presumably only develop if the same return (risk-adjusted) was obtained from
both types of lease. If the investment and occupiers market cleared
transactions of both types of property, the rent for up-or-down rent reviewed
properties would rise by the difference reflected in initial yields shown in Table
VI. The extent of the redistribution differs according to whether a short-term or
long-term view is taken. At this stage, we can only point to the differences and
admit that some redistribution will take place.

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182

Conclusions
As can be seen, the results of the analysis are illuminating. They suggest that
the effect of losing the right to restrain upwards-only rent reviews is very
significant in the attractiveness of property as an investment. Although, in
initial yield terms, a rise of 1 or 2 per cent seems relatively painless, the effect on
capital values is non-trivial, especially during the periods when there is
considerable uncertainty about the future path of rental income.
Market forces will redistribute the changes between investor, landlord and
occupier. In the long run, the investment market will adjust to the changed
opportunities and investors will only supply capital to profitable investment
opportunities.
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