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

Defining the DNA of a Luxury Brand, Nurture vs Nurture?

15th MAY 2008

Thursday, 6:30 to 9pm
Venue: Singapore Conference Hall, Spring Room.

Networking with Wine and Cheese


quote: "Success is a thought process"

We are very proud to present Mr. Richard Yong, MD of Bulgari, South Asia, speaking in his personal capacity, sharing with us his views gained from working in the luxury brand segment.

R.S.V.P. to Linlin Chua, Terence Lim. (Details in brochure close up)

Mobileone (M1) Broadband via HSDPA Creates a new broadband segment

MobileOne investments in HSDPA (HSPA) creates more competition in Broadband

During the 3G(WCDMA) bubble in 2000 and 2001, mobile operators globally overpaid for 3G licenses. In Germany, $45.2Bi was spent on licenses. HSDPA, a software upgrade on top of WCDMA(UMTS) networksii, represents an opportunity to
push the frontier of broadband mobility at a much lower cost than WCDMAiii. It is the “obvious way to bring broadband to the mass market”.

HSDPA investment accelerates in the second half 2006 with over 30 launched networks. Till date there are 141 WCDMA operators in commercial service, 137 HSDPA operator commitments and 89 launched HSDPA networksiv. Investment in
WCDMA networks will grow by double digits to 26.6B in 2009v. WCDMA network investment is the leading indicator for investments of HSDPAvi.

In the US, economic growth in 2007 will slow to 2.6% while inflation remains a concern but under controlvii. Target rates are expected to trend lower. In the ICT segment, the market leaders are Cingular Wireless, Verizon Wireless and Sprint Nextel, together accounting for 75% market share while T mobile, Alltel and US cellular with 20% of the market share. T-mobile is investing $2.75b in UMTS and HSDPA networkviii.

In Japan, Jobless rate fell to 3.99% from 4.1% in Oct 2006ix. Economic growth in 2007 is expected to improve. On the ICT segment, Softbank acquired Vodafone KK for US$15b and is starting a price warx with the market leaders KDDI and NTT Docomo to acquire mobile subscribers. Japan’s mobile ARPU at US$68.22xi is set to drop.

External impact on Singapore will be muted as the broadband and mobile operators are profitable and not highly geared. Third quarter 2006 GDP grew at 7.2% while unemployment is at 2.7%xii, PMI at 54.6%xiii. Singapore’s economy is expected to
expand at a slower rate in anticipation of a stronger Singapore dollar and a weaker US economy in the year 2007.

MobileOne spent S$47m to upgrade its network to HSDPAxiv enabling it to launch mobile broadband services on 6 Dec 2006 offering unlimited broadband between S$22 to S$68 dollars. Singtel and Starhub will follow suite in 2007. The convergence
of technologiesxv has added competition into the broadband market segment via HSDPA, WiFi/WiMax technologies.

WiFi based broadband with complete coverage will force prices down in the sub 512kbps stationaryxvi market. MobileOne’s HSDPA service will create a new segment of mobility broadband that is also well positioned for the 384,500 households still
without a broadband connectionxvii until competition responds. Incumbents are expected to move up the throughput ladder to maintain pricesxviii. Overall, the demand line will move rightxix but MobileOne will struggle to get reasonable returns from their HSDPA investment.

The cost advantage of WiFi technology compared to DSL and cable is significantxx. However new entrants are skeptical as household penetration stands at 64%xxi, required IDA to co-sponsor up to S$30mxxii before becoming willing to make the
investment. This is due to Singapore’s small market size making economies of scale difficult.

The Author:
Paul Ho works in the telecommunication OSS/BSS software sector and has 10 years of working experience ranging from Radio Network Planning, Optimisation, Integration to Pre-sales, Channel Management and direct sales experience in the Asia Pacific market covering countries from Japan to New Zealand. His profile can be found in www.linkedin.com

ABOUT MobileOne (M1) Singapore
MobileOne Ltd provides cellular mobile communications services to customers in Singapore, as well as offers international call services to both mobile and fixed-line customers. M1's mobile services comprise a range of voice, non-voice and value-added services provided on its nationwide dual-band global system for mobile communications (GSM) 900/1800 and wideband code division multiple access (W-CDMA) networks. For international call services, it offers mobile and fixed-line customers International Direct Dial services using the prefix x 002 and 021, and International Calling Card service using the prefix 1818. M1 also sells international wholesale minutes to other international service providers. In May 2005, M1 secured spectrum in the 2.5-gigahertz band for deployment of wireless broadband access (WBA) services. The Company's interests in
subsidiaries include M1 Shop Pte Ltd, M1 Capital Ltd and Wireless Intellect Labs Pte Ltd. M1 also provide broadband services through HSDPA network.

Glossary of terminologies
3G - refers to the third generation of developments in wireless technology, especially mobile communications. The third generation, as its name suggests, follows the first generation (1G) and second generation (2G) in wireless communications.
ACPU – Average Cost per User
ARPU – Average Revenue per User
DSL – Digital Subscriber Line (The line that carries broadband signals)
ICT - Information and Communications Technology
IDA – Infocom Development Authority of Singapore.
HSDPA - High-Speed Downlink Packet Access An upgrade for WCDMA / UMTS networks. It doubles network capacity and increases download data speeds five-fold or more. While the technology is theoretically capable of downlink (download) data
rates up to 8-10 Mbit/s (million bits per second), initial deployments and devices will be limited to 1.8 Mbit/s, followed by network upgrades and new devices capable of 3.6 Mbit/s. HSDPA is standardized by the 3GPP in UMTS Release 5.
HSPA – High-Speed Packet Access (HSDPA Downlink and Enhanced Uplink)

WiFi, WIRELESS LOCAL AREA NETWORK -
WLAN technologies complement access technologies for cellular networks. WLAN enable higher data rates - up to 54 Mbps - for coverage in in-door hot spots. WLAN is a short-range packet data communication between base stations and user terminals. Direct communication between terminals is also possible. There are several standards for the WLAN air interface. It is only in the last year that market developments have made it clear that IEEE 802.11b and g are the dominating standards. IEEE 802.11n is under development to support up to 540 Mbps and is planned for release in 2008. The
Wi-Fi Alliance certify to interoperability between 802.11 devices.

WiMax - Worldwide Interoperability for Microwave Access (WiMax) for short is a point to multi point, non-line-of-sight (NLOS) wireless broadband access technology. WiMax also known officially as 802.16-2004 (its IEEE name) can transfer data at rates around 70Mbps with a range of close to 30 miles all from just a single base station. The acronym for WiMax also encompases the WiMax Forum, and industry consortium that will be pushing 802.16 as a solution. The Forum is a collection of service providers, vendors and Industry leaders including Cisco, Proxim, Lucent and many others that plan to design the definitions for testing and certifying that these products are compliant and will interoperate.
UMTS – Universal Mobile Telecommunication System. As used loosely and interchangeably with WCDMA and 3G.
WCDMA – Wideband Code Division Multiple Access network. This is a 3G network. The terminologies WCDMA are used interchangeably with UMTS and 3G. Also known as CDMA DS (Direct Sequence) within the IMT-2000 framework WCDMA is the radio access technology for one of the UMTS access modes (UTRA FDD) using 5 MHz duplex channels. Combines circuit mode and packet mode initially.

Appendix A – Brief introduction of MobileOne and Glossary of terms

i
Appendix 1 – CommunicationsWeek International, Sep 11, 2000 by Peggy Salz-Trautman
and Emma McClune:
http://www.findarticles.com/p/articles/mi_m0UKG/is_2000_Sept_11/ai_65649741
ii
Appendix 5 – Ericsson CEO: HSPA operators will benefit most from mobile broadband
mass market, 15 Nov 2006: UMTS Forum; www.umts-forum.org/servlet/dycon/ztumts/umts/Live/en/umtsNews_3G_Article151106a
iii
Appendix 2 – Network Infrastructure cost per subscriber per month (OPEX, CAPEX),
adapted from GSA opinion paper: Radio Access Evolution; www.gsacom.com
iv
Appendix 3 – 3G/WCDMA-HSDPA Fact Sheet December 11, 2006: GSM/3G Market
Technology update; www.gsacom.com
v
Appendix 4 – W-CDMA RAN Equipment Growth Through 2009, dated 14 Mar 2006;
www.3g.co.uk/PR/March2006/2775.htm
vi
Appendix 3
vii
Appendix 6 – The Conference Board: The U.S. Economic Forecast; www.conference-board.org/economics/stalk.cfm
viii
Appendix 7 – T-Mobile Awards 3G Deals, November 27, 2006; www.lightreading.com/document.asp?doc_id=111308&print...
ix
Appendix 8 – Japan’s Inflation Rises, Jobless Falls to 8-Year low (Update 7), Dec 27;
Bloomberg News; www.bloomberg.com/apps/news?pid=newsarchive&sid=a30zfp.ZZOFAx
Appendix 9 - Japan’s Softbank to underprice mobile competitors ahead of number
protability, Oct 23, 2006; www.siliconvalley.com/mld/siliconvalley/news/15830351.htm
xi
Appendix 10 – Mobile Average Revenue Per User (ARPU) in USD; Adapted and computed
from ITU World Telecommunication/ICT Indicators 2006 database
xii
Appendix 11 – Singapore Key Indicators; Statistics Singapore; www.singstat.gov.sg/
xiii
Appendix 12 - Singapore Institute of Purchasing and Materials Management Business
Bulletin: December 2006
xiv
Appendix 13 – Singapore:Unlimited broadband services for under S$30 launched, March
30, 2006; Straits Times
xv
Appendix 14 – Broadband rush, by Joan Ng, December 18, 2006; THEEDGE
SINGAPORE
xvi
Appendix 15 – Convergence of Technologies in Broadband versus mobility; adapted from
Samsung Electronics Co., Ltd; Introduction to WiBro Technology Sep 10, 2004, Telecom
R&D Centre, by Soon Young Yoon
xvii
Appendix 16 –DEMAND of Broadband Versus PRICE of Broadband
xviii
Appendix 13
xix
Appendix 16
xx
Appendix 17 – Metro-Scale Wi-Fi’s Disruptive Economics, September 2005; Tropos
networks; www.tropos.com
xxi
Appendix 18 – Internet Broadband Subscribers and Household penetration; adapted and
computed from ITU World Telecommunication/ICT Indicators 2006 database.
xxii
Appendix 13