MGSM - 985T - Strategic Finance (Real Option Considerations in Property Investing)

quote: "Success is a thought process"

REAL OPTION CONSIDERATIONS IN PROPERTY INVESTING
Strategic Finance (MGSM 985T)
by: Paul Ho Kang Sang

Tel: 6100-0608

Paul Ho is available for Consulting or Permanent Roles.

Executive Summary

HardUp Pte Ltd, a property holding company is caught unprepared in the sudden economic downturn and needs to let go of one of their priced asset to raise $1m dollars, in order to move the property, they have promised to buy-back the property at a price of at least $800,000 anytime from the 3rd to 5th year. The property’s plot ratio is not optimized as the current cost to build another storey is not justified based on the current price per square feet.

Opportunist Pte Ltd evaluated the various investment scenarios and by using URA’s Price index as a proxy for calculating annual asset price volatility.

As Opportunist Pte Ltd is given the 1st right of refusal, it represents itself as an option. A series of scenarios were analyzed.

• NPV analysis
o The decision is not clear cut as asset price valuation is uncertain
• Purchasing the investment with Buy-back option
o This option is valued at $126,341, while cost is $230,000
o The buy back option is only worth $1,405, not as valuable as the impression it gives.
• The expansion option
o This option in only worth $35,330.
o The option including rental cash flow is $160,672.
• American Perpetual Option – Held into perpetuity
o As the option (down-payment) has no expiry date, some assumptions were made, and it returns a value of $1,513,135.

The bulk of the returns came from the rental cash flow and the option has very little value due to the low volatility because URA’s price index is already an aggregate weighted value. This probably reduces the volatility and option value of the investment. However due to the nature of the landed property, transaction volumes are low, URA index best represents a broad spectrum.

As the Option does not have an expiry date, the $200,000 downpayment used to buy the property becomes equity while $30,000 is transaction costs. So the true option price is around $30,000. The Investment is $230,000, the possible returns based on expansion or buy-back options range from $126,341 and $160,672 (at risk free rate), this represents a very good investment return which is amplified by a 5 times leverage.

Although the value of American perpetual option value seems arbitrary and high, Opportunist Pte Ltd can use the figure as a guide and get around the Optimal Stop time by using a Time-bounded way to re-evaluate the investment after the 5 years is up, whether it meets their internal Selling criteria. However there are also risks of Opportunity cost if asset values falls. This means that the company would then be “forced” to hold on to the option.

Overall, the management of Opportunist Pte Ltd recommends the Board to INVEST.
Introduction
The investment scenario involves a property investment scenario.

With the recent turn of economic events, HardUp Pte Ltd, a property holding company is looking to sell one of their many properties in the open market to raise cash for operational needs. As the market condition is not favourable, HardUp Pte Ltd has to make the investment attractive.

HardUp Pte Ltd put up their priced asset, for sale for at valuation of S$1 million dollars in District 15, a well-known enclave for Expatriate living. HardUp Pte Ltd has received a 5 year lease commitment with no diplomatic clause nor exit clause, therefore rental income is virtually guaranteed, but paid in arrears of 12th months. This is of not much use to HardUP as they really need to raise S$1 million dollars NOW. So HardUp Pte Ltd approached Opportunist Pte Ltd with an offer to sell the house at S$1 million, with rental contract transferred to Opportunist Pte Ltd and a buy-back guarantee option of S$800,00 anytime after 2 years, up to end of year 5 in case Opportunist Pte Ltd wants to offload the property and there is no risk of default of HardUP Pte Ltd.

The property description is: -



As HardUP Pte Ltd provides a buy-back guarantee at S$800,000 after the end of 2 years up to end of year 5. The proposition seems attractive and therefore wants to evaluate whether to go ahead with this investment.

Net Present Value Calculation



Net Present Value of investment if asset value remains at S$1m. Based on this scenario, Opportunist Pte. Ltd. should invest, based on the Risk Free hurdle rate.



However, if the asset price falls to S$921,800, NPV almost equals ZERO.



At a minimum Hurdle rate of 10% (required by Opportunist Pte. Ltd. and assuming asset value stays at S$1,000,000 the NPV just made it). It seems that the investment is borderline.
Given that this opportunity is not deferrable, the worst case that will happen is a loss of S$101,000 at a Risk Free rate of 3.8%. The buy-back guarantee only limits the loss, in the event of a loss and Opportunist Pte. Ltd loss is capped at S$101,000.



The sensitivity analysis is unable to help the management make up it’s mind. There are many un-factored variables such as Asset Price fluctuation.

METHODOLOGY

The management evaluated a few methodologies, including Monte-Carlo simulation of a large number of outcomes for multiple variables to have a better gauge of investment risk.

However, landed housing supply is lumpy and transaction volume is low, therefore obtaining these large number of relevant samples are hard. There is also time-factor uncertainty as the large number of samples would have to be obtained over ten years of record, meaning that there could be potentially data which were not comparable over the years. Other factors such as political risks, policy risks and various changes cannot be adequately factored. In other words, the analysis would only be as good as the data that you put in.

Therefore the management of Opportunist Pte Ltd decided to use the aggregated Urban Redevelopment Authority (URA) residential price index as a proxy for private property asset values. As the data is already an aggregated and weighted average index and aggregated over the whole of Singapore, this data would have less volatility than the actual investment and the management recognizes this characteristic.


Volatility Using a Lognormal Returns Table




The management have arrived at a volatility of 9.9% based on 10 years of price data and in the calculation uses a round-up figure of 10%. However it is recognized that actual price volatility in the investment property would likely be higher.

ANALYSIS OF INVESTMENT OPTION ON IT’S OWN AND WITH BUY-BACK OPTION AT $800,000

Management of Opportunist Pte. Ltd. thinks that there is another way to value this option to invest. As the investment presents itself now and has to be decided now, there is no option to defer. Management can however value the option to take up the BUY-BACK option from HardUP Pte Ltd to abandon the house at S$800,000 at a loss anytime from year 3 to year 5.




Using a Risk-neutral approach, based on volatility of 10%, the asset price varies from 606,530 to 1,648,720.




We replaced the lower value with the guaranteed buy back in year 4 and year 5.

The buy-back option is only worth 1,405 dollars (1126,745 – 1125,35), however the asset (in cash flow) that can be had from this investment cash flow alone would be worth S$126,341.

If $230,000 down-payment has to be made for this house, $126,745 is definitely not a viable investment.

The next investment scenario is to look at construction of another storey and add 1000 square feet to the build-up area at a cost of $600,000. For ease of calculation, we will assume that the project can be completed very fast and completed in negligible time.

CONSTRUCT AN ADDITIONAL FLOOR (BUILT-UP INCREASE FROM 2000 to 3000 SQUARE FEET)

The expansion option is first evaluated. The Cash flow from rental is added back into asset value during the backward induction process. The rental alone gives $125,341 value. It is still smaller than the required down-payment “option” of $230,000. Even with Expansion option, the expansion option only gives an extra $35,330, raising the asset value to $160, 672.



It is assumed that the construction continues without intrusion to the current lessee for simplicity of calculation.

ANALYSIS OF INVESTMENT

Both the buy-back option and the expansion option do not significantly increase the option value given the low volatility of the property market based on URA residential price index.

DOWN-PAYMENT = $230,000

WORST CASE ~ -$100,000
BEST CASE (With Expansion option) ~ $160,672
ASSET VALUE UNCHANGED ~ $125,341
PERPETUAL OPTION ~ $1,513,135

None of the above cases support going ahead with the Investment.

However, the investment should not be viewed purely as a Real Option with a time-limit of 5 years although that is the investment time-horizon of the investment company. The down-payment more resembles that of a Perpetual American Option.




Reference: http://finance.bi.no/~bernt/gcc_prog/recipes/recipes/node9.html, Norwegian School of Management (BI), Department of Financial economics.



This is because since the house is rental guaranteed for 5 years and at the end of year 5, Opportunist Pte Ltd could sell the house back into the open market and make a return of $125,341 (With a 3.8% hurdle rate). Based on that scenario, due to leveraging, the management would still make ~ 10% per annum on this property investment.

In the worst case scenario, if the property drops in value, opportunist Pte Ltd could opt to keep the investment option. If the net rental yield of 2.9% (Average of rental of 5 years) could be maintained, the Perpetual Option Price would be worth S$1,513,135.

Valuing a perpetual option is really hard, there are many methodologies and calculation out there. If it is perpetual, then when would be the optimal stop time? (Geoffrey Poitras, Risk Management, Speculation, and Derivative Securities) One way for Opportunist Pte Ltd to get around this issue is to evaluate the property investment in 5 years and every year thereafter. If it meets an internal hurdle rate of returns, then the company can decide to offload the investment, assuming there are better opportunities out there.

Opportunist Pte Ltd also considered to forego this opportunity and wait 1 year for another opportunity to come by. However, based on the locked in net rental yield average of around 2.9%, waiting represents leakage, the worst case scenario would likely be an asset value of $929,840.

So the key decision really lies on the holding power of Opportunist Pte Ltd. The option for holding the property perpetually, although the value is clear cut, if the property stays below the price they paid for the investment, it represents an opportunity cost of holding the property as $230,000 less $30,000 cost = $200,000 down payment is locked in perpetually until such time that accumulated rental returns exceed $200,000 at net present value plus required investment hurdle rate or if capital value re-bounds.

The company recognizes the opportunity cost of holding the property as well as the potential value of the perpetual option. As the company is cash rich, it recommends to the board to invest in the property.

References
1. Norwegian School of Management (BI), Department of Financial Economics, http://finance.bi.no/~bernt/gcc_prog/recipes/recipes/node9.html
2. Urban Redevelopment Authority (URA), Realis time-series data.
3. Risk Management, Speculation, and Derivative Securities, Geoffrey Poitras, pg 525

Paul Ho is available for Consulting work. The range of services provided: -
1) Equity analysis (Buy side research)
2) Doing a feasibility Study for business ideas. (Individuals with an idea and not sure whether they should make the plunge, should contact me. I can analyze the business idea and prepare a business plan with go to market strategy)

3) Corporate management consulting or projects.

Call me at 6100-0608

Links to Singapore Property Books

BANKS TURNED THE TABLES ON HOME OWNERS

quote: "Success is a thought process"

Just looking at some time ago...

BANKS WERE EAGER
The process of sourcing for Financing for your New Home, under construction home or refinancing is fairly easy. Banks are falling over themselves to lend out money. Anything can be considered.

CUSTOMERS WERE BOSS
Customers would shop for the cheapest package, the best loan, etc. You find the best loan then you submit into the bank for approval.

and compare it with NOW...

BANKS ARE NOW WARY
Now banks view anything that walks as a sub-prime risk. With properties valuation dropping, many banks have tightened credit. Some banks have stop Term Loans Outright.

CUSTOMERS ARE SQUEEZED
Now, customers are increasingly not in a position to obtain the best possible packages. The old method of finding the best package and then applying for a loan does not work anymore unless you have millions of dollars and a stable income. Now it is, "which bank dare to lend you money." If you pass their Credit ACID tests, then you choose from the packages that they have and you optimise the mix and match of packages.

It is amazing how quickly the tide turns. When that happens, many people inevitably get burnt.

What is sad is, most banks are flushed with cash during the good times. Banks will try to lend money to you when you least need it. Cheap credit leads to asset price inflation, many people end up over-paying for properties.

When the tide turns, property prices start to fall, the bank's Loan to Valuation (LTV) increases. This causes the banks pain, if the fall is severe enough (i.e. >20%), that will typically wipe out the most recent Home Loans which were borrowed at 80% financing. Banks will start to tighten.

During this time, many people will need money for various reasons. And Banks, instead of lending out money to smooth out the economic decline for a soft landing, further tighten their credit, exacerbating the severity of economic slowdown.

It is a typical of a boom and bust cycle. So don't let this BOOM and BUST economic Chameleon catch you... It could be painful.

US GOVERNMENT KNEW ABOUT THE FINANCIAL CRISIS IN 2006

quote: "Success is a thought process"

The fundamentals of the economy is strong, John McCain the US presidential candidate said in 2008.

I think the US companies are probably one of the most competitive on earth. BUT the US economy is fundamentally strong?

US Trade secretary Hank Paulson visited China in 2006 at the behest of George Bush. During the visit to China, he addresses issues such as trade imbalance, and lectures China on over-saving and pressures China to re-value China's currency.

One of the issues was that China used it's massive savings to buy US treasury bonds. This in effect finances the US trade deficits, but on the other hand, it keeps China's Yuan artificially low as the reserves/surplus was immediately shipped out of China.

I remember (though I can't find the article, someone who has it, please send it to me) that Hank Paulson was asking China to diversify it's reserves. He was actively Touting Freddie Mac and Fannie Mae bonds to China, in that visit.

China said, thanks but NO Thanks.

Hank Paulson was the ex-CEO of Goldman Sachs, he has enough knowledge to know that Freddie Mac and Fannie Mae were time-bombs waiting to blow up. The US government was smart enough to ask China to buy those useless bonds as early as 2006.

In fact the problems of Sub-prime dated back to the early 2000, but over-leveraging, off-balance sheet risks and derivatives were probably started much earlier.

What I could not understand is that, what the US government saw was the "train" running out of tracks, but did not do anything to stop the Financial Train from crashing. Neither did it do anything to slow down the train.

Had China bought Freddie Mac and Fannie Mae bonds in large amounts (like Hank Paulson suggested China should do), these 2 over-leveraged companies would have been able to delay facing the "music" and continue to lend irresponsibly. The US government bail-out would not have been necessary and in case they go bankrupt, China would have been burnt the most.

So the key thing to do is, read more, learn more. Do not despair when it seemed hopeless (for hope is around the corner) and do not GREED when everything seemed perfect (Doom often follows greed). So many of these BOOM and BUST cycles are timed almost to perfection for the well-informed to get more wealthy while the rest gets burnt.

If you think that following the crowd is safe, then you would be happy to know that in the USA, 5% of the people control 90% of the wealth. If the crowd is right, then wealth would be distributed more evenly.

Now that things are very bad and it is set to get worst. But do not despair, people like Warren Buffet has begun to take biggest stakes in well run companies whose share prices have been beaten down. So controlling the emotions is the key to maintaining your wealth in this volatile market.