SIFR Research Report Series,
Institute for Financial Research

Abstract: We consider the term structure of lease rates in a general setting where both the interest rate and the short rent are stochastic. Our framework is applicable to any leasing market, but we focus on real estate. We find that the “expectations hypothesis” of lease rates, i.e. that the forward rent is an unbiased estimator of the future short rent, requires similar assumptions as in interest rate theory to hold. To study the magnitude of the bias we parameterize our general framework. The simulations show that different realistic parameter values for risk aversion and interest rate stochastics can generate widely different shapes of the rental term structure, holding the objective rental expectations constant. As a result, an expected increase in rent may very well be consistent with a downward-sloping term structure and vice versa.

Keywords: Term structure of lease rates; Rental expectations; Expectations hypothesis; Lease valuation

JEL-codes: G00; R00

26 pages, October 13, 2003

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