Curvature and Contingencies: Pricing Lease Term Risk in Commercial Real Estate

Abstract

Lease duration presents landlords with a fundamental choice: secure near-term cash flows or preserve flexibility for uncertain future states. We document that commercial property markets price this trade-off with considerable sophistication. Analyzing 8,293 U.S. single-tenant transactions (2000-2019), we find capitalization rates compress steeply with term initially but flatten substantially beyond 20 years-a convexity explained by competing insurance (against near-term rollover) and encumbrance (from long-horizon uncertainty) effects. We develop an option-theoretic framework that predicts this curvature and its systematic variation. Testing these predictions, we find the curve's shape varies with tenant reliability, property characteristics, market tightness, and climate exposure. These findings extend real-options leasing models, quantify heterogeneity absent in prior aggregate studies, and offer practical insights for lease structuring and portfolio management amid multidimensional trade-offs between certainty and flexibility.

Keywords: Lease Duration, Capitalization Rates, Single-Tenant Net Lease, Real Options, Tenant Credit, Market Tightness, Climate Risk, Hedonic Pricing

JEL Classification: G11, G12, G14, R30, R33, Q54