A Coasean Sign

Last fall, I spoke at an SPSS conference in Las Vegas. As I was heading home, I saw a sign on a convenience store (right next to Bally’s) that made me do a double-take. I got so interested that after a couple of blocks, I convinced my driver to turn around and let me go back to take these pictures:

INSERT DESCRIPTION

In case it is difficult for you to read, the convenience store seems to have renamed itself “We Have 22 Years Left On Our Lease.”

INSERT DESCRIPTION

When I asked the driver, he told me that more than a year ago, the landowner and the tenant had a big legal dispute. The landowner had tried to sell the property “out from under the lease” for another use. The tenant who runs the convenience store had taken the landlord to court and had succeeded in getting an injunction blocking the sale and enforcing the 22-year lease. (Mini bleg: Is this true? Do readers have any details on the dispute?)

From the street, there is strong visual evidence that a quickie mart is not the “highest and best use” for this property. It is surrounded by high-rise hotels and is just off the Vegas main drag.

The court decision enforcing the leasehold doesn’t mean, however, that the property will be used inefficiently for 22 years. It just means that the landlord needs to buy out the tenant’s interest. Such a deal would be an example of the Coase Theorem at work. Ronald Coase was the first to see that the decisions of courts and legislators might have less to do with how resources are allocated and more to do with who had to bribe whom to do what was jointly efficient. (You can find Levitt’s description of the theorem and examples of when it sometimes fails here.) Unless both the tenant and the landlord agree, the property will be misused for more than 20 years.

The interesting question is: How much should the landlord pay?

This is the perfect kind of question for corporate finance students to kick around in Excel, and so as one of the questions for my quantitative corporate finance final, I asked them to help complete this post.

I asked them to make the following assumptions:

The Las Vegas real estate market is now in a severe slump. But imagine that the current and future value of the property, if it is unencumbered by the lease, is $5 million. The convenience store owner is currently making $600 a month as a net profit on the store after all expenses (including $3,500 monthly lease payment to the landlord). To keep the problem simple, assume that there is no inflation, no expected growth in either the tenant profits or in the rental payments, and that the risk-adjusted market interest rate on both the store profit and on the lease payments is an annual interest rate of 6 percent (effective yield, not APR). Finally imagine that the landlord and the store owner have equal bargaining power, in the sense that they will split any gains of trade from cutting a deal.

(Let me be clear, these assumptions are not intended to be realistic. I was trying to craft one question that could be answered in Excel in three hours. I doubt that, even in the best of times, the property was worth $5 million. And in all likelihood, the lease payments may be subject to an escalator clause that increases them overtime.)

You can play too. What’s the bargaining range — the range of dollar amounts that landlord could potentially pay today to bring the parties to the table — for a potential buyout deal? And what percent of $5 million does the landlord need to offer, given his “equal bargaining power” as described above?

In a world with equal bargaining power, who would get the lion’s share of this land bonanza: the landlord, who after all owns the land, or the tenant, who can legally gum up the works for year? Twenty-two years is an awfully long time.

I’ll spare you the Excel spreadsheet, but here is a sketch of an answer. The landlord would need to pay the tenant, at a minimum, about $90,000 — because the present value of the tenant’s expected store profits is about this amount. Even a landlord who could make a take-it-or-leave-it offer would be ill-advised to offer less than this. And at most, the landlord should be willing to pay $3.1 million. Since the present value of the landlord’s expected profit from the lease together with the present value of selling the land when the lease ends is about $1.9 million, the landlord would be loath to pay a lease buyout fee that would leave her with less net on the table.

A successful buyout raises their combined payouts by about $3 million (from $2 million to $5 million). If they split these gains of trade, then the tenant must be paid her minimum of about $90,000 plus half the gains of trade of about $1.5 million, which is very roughly about one-third of the $5 million.

So in the real world, why didn’t they cut a deal? We’d need to get rid of these hypothetical numbers and know a lot more about the offers and counteroffers. But the sign is, well, a powerful sign that the Coase theorem in this instance did not hold.

By the way, I was back in Las Vegas last week and the sign is still there — although it now says “We have 21 years left on our lease.” A Blackjack lease.

Leave A Comment

Comments are moderated and generally will be posted if they are on-topic and not abusive.

 

COMMENTS: 37

View All Comments »
  1. Imad Qureshi says:

    I think coase theorem can work if both act rationally. The problem is ego might prevent one of them probably the land lord from doing so. I learned that hard way by refusing to get a good deal on something just because of stupid principle.

    Thumb up 0 Thumb down 0
  2. Allison says:

    If the buyout had been attempted before they went to court, it may have been successful, but human nature is going to trump reason once people start getting cranky.

    Thumb up 0 Thumb down 0
  3. DrS says:

    Imad hit the nail on the head. Even if the assumptions you set up were correct, do you think the rich and powerful guy who owns a 5 million dollar piece of property is going to give an inch or a dollar to someone who makes 600 dollars per month? Ego Ego Ego.

    He would probably figure out that he can starve him out, or that it would be cheaper just to pay to have him “taken care of”.

    Thumb up 0 Thumb down 0
  4. Joe says:

    Maybe the store owner loves running the store so much, that no monetary amount will chase him away. A simple case of assuming that money is all it takes, and is the only thing that has has value.

    Thumb up 0 Thumb down 0
  5. Proudhon says:

    The tenant’s “ego,” however, is simply another factor when determining the utility derived from the land. If it costs the landlord more to get rid of the tenant because of the tenant’s ego, what that really means is the tenant’s subjective utility derived from the land is higher than the landlord’s calculation of what a tenant’s utility derived from the land might be. Simply stated, the landlord needs to compensate the tenant to at bear minimum cover the tenant’s derived utility from the land, regardless of how that utility is derived

    Thumb up 0 Thumb down 0
  6. Anon says:

    They put the sing up to give notice to any potential buyer. The lease may not be recorded in the public records (some leases don’t allow it), so a potential “good faith purchaser” of the land who doesn’t know about the lease can’t kick them out. Hard to imagine a court would ever find a sophisticated commercial buyer could be ignorant of the lease in “good faith”, but this seems typical of the over cautiousness some folks take with the law. Also, they probably enjoy sticking it to the Landlord.

    Thumb up 0 Thumb down 0
  7. Bart says:

    A leasehold estate can be valued like any other interest in land. So, a competent commercial appraiser could be engaged to value the leasehold estate. This would essentially be the net present value of the cash flow produced by the tenant subletting the land at current market rates, less the current rent paid to the landlord, less any associated costs, over the remaining 22 year term of the lease. That is what the landlord should be willing to pay to buy out their tenant.

    The key to leasehold value, from a real estate perspective, is the difference between the contract rental rate and the market rate. From this point of view, the cash flow of the business is inconsequential. (For those who don’t believe me, I’ve been involved in the sale of many standalone retail outlets, and my experience is that the value of the underlying land is a better indicator of sales value than the retail numbers the store is producing.)

    Thumb up 0 Thumb down 0
  8. Ben says:

    It’s great to teach Coase theorem and all, but really, you’re posing this question without reference to the current Las Vegas housing market, or the general lack of availability of financing? Really?

    Thumb up 0 Thumb down 0