A Coasean Sign—A Commentary by Ian Ayres ’86
The following commentary was published in The New York Times on March 18, 2009.
A Coasean Sign
By Ian Ayres ’86
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:
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.”
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 loathe 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.