A reduced-form model for lease contract valuation with embedded options

This paper provides an analytical formula for valuing lease contracts in the most general case, including adjustable leases, with cancellation, purchase, and default options. We then illustrate the numerical implementation of our model. Numerical analysis reveals that the lessor offers a discount on the initial rent for a longer-term lease contract but charges an additional amount for cancelation, purchase, and default risk compared to the contract without any embedded options. This result suggests that ignoring embedded options in valuing a lease contract leads to significant pricing errors. Thus, we provide a framework to value complex lease contracts and enhance real-estate lease portfolio management efficiency.