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:

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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.”

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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.


Imad Qureshi

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.

Allison

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.

DrS

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".

Joe

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.

Proudhon

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

Anon

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.

Bart

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.)

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Ben

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?

david

1. The store might only "profit " $600 a month. But it is likely providing work for several members of the store owner's family. He/she would have to find replacement jobs for those family members if there is any desire to go to family reunions in the future.

2 Highest and Best Use: In a down market, HABU might be hold for future developement. So the current use- collect that rent and wait several years (5 or 10) for the economy to improve - may well be highest and best use.

Larry Mathena

Presumably when the lease was entered into the parties acted rationally. The fact that the land piece of the transaction has apparently grown in value more than the parties could have expected is irrelevant to the deal they struck.

The tenant piece of the transaction could (depending on the circumstances) similiarly have exploded in value for a wide variety of reasons- assume that suddenly this area became a high rent district and the tenant could safely assign the lease to Tiffany's.

They cut up the property interest some time in the past and now the Landlord is unhappy because in hindsight he contracted away more rights than he should have.

In the absence of eminent domain leverage there is nothing- nothing to require the tenant to accept your "rational" determination of value for him or a "rational" allocation of value from the landlord's side. Indeed the tenant may hold some believe that his business or perhaps some successor business will be amazing profitable- your exercise is appropriate to MBA classes only- ultimately the Highest and Best Use of the tenant's leasehold interest is whatever he decides it is- that's the cool thing about this country and the real lesson of all of this is that be careful what you contract to- you may regret it for a very long time.

Larry

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jonathan

I've been in this situation.

1. Most small leases don't allow assignment or subletting, though if this mart is a franchise there might be some assignment allowed. State laws vary but Nevada is not tenant-oriented and I'm fairly sure this is a bargaining issue, which means likely none in this lease except under very specific circumstances. Thus the value would not be rent the tenant might obtain from someone else.
2. The issue is not so much rationality as where any potential development might stand. A developer might buy on spec but he then has to factor in carry costs, permitting risks, disposal costs if the deal doesn't work, and the source of funds for spec buying. Maybe he has a line of credit, but as a developer you want the money rolled into a loan tied to that collateral. Lots of reasons for that.
3. So if no development is actually set - and the market is not hot enough to buy on spec unless at a cheap price - the right answer is actually to option purchase the tenant's leasehold, allowing the tenant to stay in place until and unless. The cost for that option should be relatively negligible. I've found that people are willing to agree to things that might happen in the future in exchange for money now. Again, it's not so much rationality as timing.
4. As a btw, developers will try to find relocation opportunities, including talking to franchisors, etc. about other spots.

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Michael F. Martin

Ward Farnsworth had some interesting things to write about a related problem here:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=164348

I no longer recall what alternative theory Prof. Farnsworth offers, but I have a few of my own.

People like a challenge, and occasionally an eminent domain proceeding provides a person who may otherwise lack challenges in their day-to-day life an opportunity for public recognition and exercise of their mental and physical faculties in opposition to a would-be developer. The other example that comes to mind is of the woman who opposed Trump's casino development. There are enough to question the limits of rational choice theory in this context, although the Coase Theorem should be left alone since Coase's main point was that transactions cost are never zero, and should therefore be a focus. I'm not sure even that Coase's view of transactions costs was so narrow as to preclude a kind of psychological theory that would recognize the need for challenging experiences in day-to-day life. But that would be at the limits anyway.

The larger point, I believe, is that inefficiencies must be tolerated in any system design to avoid systemic failures. Like the fourth leg of a table, such inefficiences can add wobbles. But with only three, the table is more likely to come crashing down.

http://brokensymmetry.typepad.com/broken_symmetry/2008/05/vacant-lots-thr.html

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Michael F. Martin

I should say also that wholly apart from the challenge of an eminent domain proceeding, the day to day work of running a convenience store in a particular location may provide unique challenges that are unlikely to be matched elsewhere, especially when the store has developed a long history of serving particular customers. It is understandable that some people would be unwilling to give that up for any price. Not everybody values money over particular kinds of life experiences.

Caliphilosopher

I actually went to this store during my last trip to vegas, and took a picture of it as well.

However, my question is this: Who says this property is being "misused"?

The person leasing this might want to keep this here because of something more important than money. Why make unrealistic assumptions (in the economists' own words) when trying to project a "real" outcome for a "real" situation?

Also, if the landowner doesn't want to broker a deal, they're not acting "irrationally" - unless, of course, you're tying rationality to amount of money potentially made. Which, in that case, you get into the current economic crisis that we're currently in.

BSK

Why is the assumption that convenience stores aren't useful? Maybe the land value would imply that a more "lucrative" business exist there, but that doesn't mean there isn't value to the convenience store. I know that when I travel, convenience stores are just that: convenient. And they are a welcome commodity nearby my hotel.

Ryon Day

What in the world are you people talking about?

Maybe the Tenant enjoys running the store

Maybe everything doesn't have a dollar value.

Maybe your next article would be about whether the gold in Jewish teeth was worth enough for the Nazi's to extract it

Economists make me ill inside.

A.J. Sutter

You say "Unless both the tenant and the landlord agree, the property will be misused for more than 20 years." So it would not be misuse if the property were used instead for ... a casino? a house of prostitution? a hedge fund's headquarters? Why are any of those better uses -- from the community's perspective -- than the services offered by a convenience store? Your crtieria for "misuse" seem rather shallow.

Travis Ormsby

The inference that the Coase theorem has broken down in this case is wholly based on the assumption that the property is being used sub-optimally.

Even assuming that the landowner offered the full $5 million market value to the leaseholder, it's still possible that the leaseholder could rationally reject the offer. The net profit from the store is not the only benefit that the leaseholder derives from operating the store.

The sign seems to indicate that the leaseholder derives a great deal of pleasure from thumbing his nose at the landowner. Without knowing exactly how much pleasure that is, it's impossible to say that the best use of the land is for some other purpose than the convenience store.

That's the problem with the corporate finance analysis of this situation. It utterly fails to take into account the non-tangential benefits of the store owner.

Larry Sheldon

Some times the cat wins, sometimes the mouse does.

This guy figured he would get a better price from the University.

Last time I heard anything about it he was looking for charity to get him cable television--the hospital blocks over-the-air, and the cable companies would run a cable for one house.

http://maps.google.com/maps?hl=en&ie=UTF8&ll=41.264243,-95.953946&spn=0.001563,0.003487&t=h&z=19

Liudvikas Bukys

What I learned in business school was that there is a real option here, and the volatility of the real estate market makes the option worth more.