The Economics of Commercial Real Estate Preleasing

Abstract

Preleasing of to-be-built commercial real estate space is a pervasive worldwide practice. Although such preleasing is an extensive and significant activity, it has not received much attention in the real estate economics and finance literature. Using an equilibrium micro-economic agency model, this paper examines the economics of preleasing for to-be-built commercial real estate. The equilibrium prelease contract rent is a function of several variables, including the expected spot market rent, financing benefits from preleasing, developer-lessor and tenant-lessee risk-hedging behavior, the interplay between lessor and lessee default options, and the market capitalization rate. Our paper demonstrates how the distribution of risk preferences for lessees (and lessors) generates separating market equilibrium for the prelease and spot lease. We also consider the impacts of developer default and the lessee cancellation clause on the prelease rent equilibrium.