The book, “Stalking the Black Swan” talks about how to make decisions in a volatile world, and it includes case-studies from the fast-moving world of financial markets, where reacting accurately to new data is a critical survival skill.  However, as my friend Howard Ecker points out, individuals may be able to take out “insurance policies” against Black Swans by structuring certain kinds of options into long-term contracts.  The idea is to build flexibility into long-term contracts, so that if and when crisis strikes, the firm has room to respond.  Howard is an experienced commercial real estate practitioner, and many years ago I worked with him to structure options in commercial real estate leases to protect corporate tenants from financial volatility.

As a reminder, Black Swans are Nassim Taleb’s term for seemingly unpredictable surprises with extreme impact.  Commonly associated with the Great Recession we have recently experienced (and whose after-effects still linger), Black Swans can also impact individual companies or industries, even when the rest of the market is calm.  For example, in an earlier post (August 22, 2010), I described how a company called APEI suffered a Black Swan that knocked 50% off of its stock price in 5 days.  Each chapter of “Stalking the Black Swan” contains examples of one or more Swans and a discussion of their causes.

One cause of Black Swans is leverage, which includes not just debt, but any kind of fixed cost.  Real estate developers commonly fall victim to Black Swans, because they operate with high leverage, which leaves them exposed to a correction in real estate values.  However, volatility in property markets is also a problem for tenants.  For many firms, long-term commercial real estate leases are a major fixed cost and thus potentially a source of dangerous leverage (this is why analysts treat leases as if they were debt obligations when analyzing the risk of a firm’s balance sheet). 

Consider a hypothetical law firm with a practice in commercial real estate that signs a long-term lease at the top of the market.  Or a securities firm that expands when stocks are booming.  When the inevitable bust arrives, the firm’s revenues drop, yet the costs of its lease remain fixed.  As a result, margins are squeezed.  If the crunch is tough enough, the firm may turn unprofitable.  Even if it maintains a positive cash flow, it may have to cut wages or let go staff, which makes it less competitive.  Conversely, an unexpected boom can produce a surge in revenues and expanding margins.  However, if many firms are doing well, they may compete for space for their expanding operations, in the process bidding up rents.  If this happens at the peak, then firms which lock in high-priced space could find themselves in a difficult position when business slows.

As Howard reminds me, you can mitigate some of this kind of Black Swan risk by structuring options into long-term leases.  These options come in different flavors:

• A cancelation option allows the tenant to terminate the lease (or a portion of the lease) at a specific date, providing flexibility for the firm to downsize operations and cut costs if business is suffering.
• Many leases have renewal options, but these terms are more valuable if they specify a fixed rental rate for the renewal period.  This option protects the tenant from having to pay sky-high rates if the commercial real estate market tightens, which as pointed out above could set the tenant up for problems in a market correction.  Yet if the market softens, the tenant is under no obligation to exercise the fixed-rate renewal option, but may instead negotiate a renewal at the prevailing market rate.
• Options to expand the space under lease at specific fixed rates provide similar benefits to fixed-rate renewal options.

In the 1990s, I published several articles on how to estimate financial values for these options, as a guide for savvy tenants and their representatives (for example, see “The value of options in real estate leases,” Journal of Property Management, May 1994).  Even without putting specific values on the options, however, it should be clear that they provide excellent insurance against Black Swan risk by building flexibility into what are otherwise long-term, fixed-cost contracts.

Building flexibility into contracts is an idea that has many applications in a volatile world.  For example, bank regulators are experimenting with so-called “living wills” which would make it easier to wind down big banks if they got into trouble (instead of having to bail them out).  Another idea is to have big banks issue a kind of “contingent capital” which would automatically replenish their reserves during a financial crisis. (You can find a discussion of these ideas in my recent article, “Thoughts on the Squam Lake Report,” in the Journal of Applied Corporate Finance, available at www.stalkingtheblackswan/articles.html).