Long Term Ground Leases, the Redevelopment Option and Contract Incentives

Since the option to redevelop a property is valuable, ground leased property should trade at a discount relative to fee simple property because of the impairment of the value of that option resulting from the foreshortened horizon of the leaseholder. This discount would be over and above the discount that results from the leaseholder’s non-existent residual claim to the property. We evaluate alternative contractual arrangements that may be more incentive compatible between the owner of the leased fee and the leasehold. We find that a lease extension clause causes the lessee to defer development and develop at much higher density. Sharing of the value of the residual claim between the owner of the leased fee and the leasehold also increases the intensity of redevelopment but results in earlier redevelopment. Also, we find that a more realistic escalation clause causes redevelopment to occur sooner but at similar density.