Consider a commercial office space available for lease in a high-demand area (CBD). A contract currently being negotiated that has not yet been signed is a 10-year net lease, fixed at $850/m2 per year in arrears. Operating expenses are estimated to be 17% of the rent. The tenant applicate wishes to include a tenant improvement of refitting the space for a high-speed LAN network, which is expected to cost $400/m2, to be completed as soon as the contracts signed and to be paid by the landlord. The landlord's discount rate is 12%

A.From the perspective of the Landlord what is the effective rent of lis agreement with tenant improvement? (2 marks)

B. From the perspective of the Tenant, what is the effective rent of this agreement with tenant improvement? The tenants discount rate is 18%.

In exchange for the tenant improvements, the landlord wishes to include an option to cancel the lease after year 3. Forecasts at year 3 show there is

20% probability that market rent will reduce to $800/m2

40% probability that market rent will remain at $850/m2

30% probability that it will increase to $890/m2

10% probability that it will increase to $935/m2

C. The landlord's inter-lease risk premium is only 3%, as they are very confident that they can find a new tenant at market rent within a short turnover. From the perspective of the Landlord, what is the effective rent of this agreement with option? What is the price of the option?

D. Assuming the tenant values the option the same as the landlord, is the tenant better off agreeing to the customised lease, or removing both the improvements and option?

E. Define release costs and discuss whether they tend to extend on shorten tenant and landlord consideration of the lease term.