A renewal at a percentage of market and a renewal at a fixed rent look alike in the lease. One is a discount, the other is an option, and they react to uncertainty in opposite ways.
A lease renewal option is worth the rent saving it gives the tenant over the renewal term, weighted by the markets in which the tenant would use it and discounted to today. On an illustrative 20,000 sq ft lease, a five-year renewal at 95 per cent of market is worth $40,000 a year, $164,008 at the start of the renewal and $116,935 today. A fixed renewal rent of $44.00, 10 per cent above today's $40.00 market, looks worthless but is worth $87,702 today, because the tenant only exercises it when the market has moved above it.
Worked in full in How to Read a Commercial Lease by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Renewal options are often read as a formality: the tenant may stay, at a rent to be agreed. The clause that sets that rent is the one that moves value. There are two common forms, and they behave in opposite ways. A renewal at a percentage of market rent gives a discount that the tenant collects in every market. A renewal at a fixed rent gives the tenant a call option: it costs the landlord nothing when the market is below the fixed rent and a great deal when it is above.
| Input | Value |
|---|---|
| Area | 20,000 sq ft |
| Market rent today | $40.00 per sq ft |
| Years to the expiry and the option date | 5 |
| Renewal term | 5 years |
| Option A: renewal rent | 95% of market at expiry |
| Option B: renewal rent | $44.00 fixed (10% above today's market) |
| Discount rate | 7% |
| Market rent at expiry | $30.00 (25%), $40.00 (50%), $50.00 (25%) |
The three markets average $40.00, so the case assumes no rental growth on average. That isolates the option: any value below comes from the clause, not from a forecast that rents will rise.
| Market at expiry | Probability | Option A rent | Option A saving a year, $ | Option B exercised? | Option B saving a year, $ |
|---|---|---|---|---|---|
| $30.00 | 25% | $28.50 | 30,000 | No | 0 |
| $40.00 | 50% | $38.00 | 40,000 | No | 0 |
| $50.00 | 25% | $47.50 | 50,000 | Yes | 120,000 |
| Expected | 40,000 | 30,000 |
Option A's saving is 5 per cent of whatever the market is, so it moves in a straight line: $30,000 in the weak market, $50,000 in the strong one, $40,000 on average, exactly 5 per cent of the expected renewal rent of $800,000. Option B pays only in the strong market, where the tenant keeps a $6.00 gap on 20,000 sq ft, $120,000 a year. In the other two markets a tenant who wants to stay negotiates at market and ignores the option.
Option A saving = (1 − 95%) × market rent × area
Option B saving = MAX(market rent − fixed rent, 0) × area
Expected saving = Σ probability × saving. In Excel, with markets in B2:B4, probabilities in C2:C4, the fixed rent in F1 and the area in F2: =SUMPRODUCT(C2:C4,(B2:B4-F1>0)*(B2:B4-F1))*F2
The saving lasts the five years of the renewal, not for ever. At 7 per cent the five-year annuity factor is 4.1002, and the renewal starts in five years, so the discount factor to today is 0.7130.
| Option | Expected saving a year, $ | Value at the start of the renewal, $ | Value today, $ | Per sq ft today |
|---|---|---|---|---|
| A: 95% of market | 40,000 | 164,008 | 116,935 | $5.85 |
| B: fixed at $44.00 | 30,000 | 123,006 | 87,702 | $4.39 |
Value today = expected saving × (1 − (1 + r)−n) ÷ r × (1 + r)−t
$40,000 × 4.1002 × 0.7130 = $116,935. In Excel: =PV(7%,5,-40000)/(1+7%)^5
For a buyer of the building, that is the amount by which the renewal clause reduces the value of the reversion compared with a clean expiry at market, on the assumption that the tenant stays; where renewal is uncertain, weight it by the renewal probability. For the tenant, it is what the clause is worth in a negotiation over the headline rent or the fit-out contribution.
This is where the two clauses part company. Hold the average market at $40.00 and widen the range on either side:
| Spread, $ per sq ft | Weak market | Strong market | Option A today, $ | Option B today, $ |
|---|---|---|---|---|
| 0 | $40.00 | $40.00 | 116,935 | 0 |
| 5 | $35.00 | $45.00 | 116,935 | 14,617 |
| 10 | $30.00 | $50.00 | 116,935 | 87,702 |
| 15 | $25.00 | $55.00 | 116,935 | 160,786 |
| 20 | $20.00 | $60.00 | 116,935 | 233,871 |
Option A is worth the same in every row. Because its saving is a fixed share of the market, the weak and strong outcomes cancel, and only the average matters: running scenarios adds nothing to a percentage-of-market option. Option B is worth nothing if the future is certain and grows steadily with uncertainty, overtaking Option A once the spread passes $12.00, that is once the strong market reaches $52.00. The landlord has sold the tenant the upside and kept all of the downside, since in the weak market the tenant simply renegotiates.
The same logic sets the fixed rent at which the two clauses cost the landlord the same on the base case: $42.00, 5 per cent above today's market. A landlord who accepts a fixed renewal at that level because it is above today's rent has given away as much as a 5 per cent discount on the whole renewal.
Two, and they push in opposite directions. The first is valuing a fixed renewal rent against today's market: $44.00 against $40.00 reads as a $4.00 benefit to the landlord, when the clause is worth $87,702 to the tenant. A fixed renewal rent is an option, and an option struck above today's price is still worth something. The second is capitalising the discount in perpetuity. $40,000 a year divided by 7 per cent is $571,429, 3.5 times the $164,008 the clause is worth over its five years. The discount ends when the renewal ends; the next renewal is at market unless the lease grants another option.
A renewal option also has value to the landlord: a tenant that renews saves the void, the free rent and the fit-out of a new letting. That benefit belongs in the renewal probability, not in the option value; the figures here are illustrative and are not advice on any lease.
The renewal option is priced across three markets in the free workbook and cases for this book, inside the lease-by-lease mark-to-market. The probability that a tenant renews at all, which sits alongside the option value, is worked in how to blend renewal probability into leasing assumptions, and the opposite right, the tenant's break, in what a tenant break option costs the landlord.
Yes: it is a 5 per cent discount on the renewal rent in every market. On an illustrative 20,000 sq ft lease with an expected market of $40.00, that is $40,000 a year, $164,008 over a five-year renewal at a 7 per cent discount rate and $116,935 today if the renewal starts in five years. It is worth the same whatever the spread of possible markets.
As a call option: weight the saving in each market where the market rent exceeds the fixed rent, and count zero elsewhere. A $44.00 fixed renewal against markets of $30.00, $40.00 and $50.00 is exercised only in the strong market, saving $120,000 a year with a 25 per cent probability: $30,000 a year expected, $87,702 today.
No. The discount lasts only for the renewal term. Capitalising $40,000 a year at 7 per cent gives $571,429, 3.5 times the $164,008 the five-year renewal is actually worth at its start, and overstates the clause's effect on the value of the building.
This article is one calculation from How to Read a Commercial Lease. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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