Commercial Real Estate Market Property Level Capital Expenditures: An Options Analysis

Option pricing theory predicts that capital improvement expenditures are positively linked with high or increasing market lease rates. Ceteris paribus, when the market lease rate is high, or when there is an expectation of higher lease rates in the future, owners are encouraged to increase investment to capture a larger profit. In contrast, when the market lease rate is low, or when there is an expectation of lower lease rates in the future, owners are encouraged to defer capital improvements, causing a skewness in the cash flows. Our empirical results generally support the notion that normal levels of capital expenditures not only maintain value but also actually may create value.