Valuation of Real Estate Leases

Peter Buchen and Kevin Ho-Shon

Abstract

The arbitrage free price of a real estate lease satisfies the Black-Scholes pde with a reflecting boundary condition. We show how to solve such problems using the method of images. While absorbing BV problems need only simple point images, reflecting BV problems require cointinuous distributions of images. This feature introduces complexities in pricing lease contracts which are not present in simpler contracts such as barrier options.

Keywords: real estate leases, real options, Black-Scholes pde.