REAL OPTION CONSIDERATIONS IN PROPERTY INVESTING
Strategic Finance (MGSM 985T)
by: Paul Ho Kang Sang
Tel: 6100-0608
(Paul Ho Kang Sang is available for consulting roles for companies and corporations)
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.
METHODOLOGYThe 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
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