REAL OPTION CONSIDERATIONS IN PROPERTY INVESTING

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.

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

MORTGAGES FAQ - SINGAPORE

TYPES OF MORTGAGES
By www.PropertyBUYER.com.sg
09 Nov 2008

The numbers stated herein are for illustration purposes only.

Fixed Rate Packages: -
This is the most traditional package. Home owners have certainty over future payment amounts. Fixed rate packages are often discounted off from a “Board Rate” or “housing loan rate” or some other terminology introduced by the bank. Fixed rate loans may be offered for 1 year, 2 years or longer depending on the prevailing packages that banks offer.

For example, a bank may have a “board rate” of 5% while they can offer a housing loan to you at 3%. This simply means that the bank offers you a loan of (Board rate – 2%)

Staggered Fixed Rate Packages
Often Banks would try to induce customers to sign-on to a package with a cheap entry point, but the bank would typically make their money back in the later years with more expensive interest rates. The function of increasing interest rates in later years plays 2 functions, 1st as a means to increase profitability, 2nd as a means to reduce the risks as banks undertake risks in guaranteeing fixed rates.

For example: -
• Year 1 = “Board Rate 5% – 2%” = 3% (fixed for 1 year)
• Year 2 = “Board Rate 5% - 1.5%” = 3.5% (fixed for 1 year)
• Year 3 = “Board Rate 5% - 1%” = 4% (fixed for 1 year)
* Year 4 onwards = "Board Rate" = ???% (Prevailing Board Rate at the 4th year)

Depending on the bank, the bank may specify that the rate is Board Rate - 2%, board rate - 1.5%, etc, at the point of issuing the offer, however the Board Rate is only used as a reference and serves no purpose other than to build into the document the "Board Rate" because on the 4th year, the interest rates reverts to "BOARD RATE".

Other banks may completely omit mention of the board rates if their later years reverts to a SIBOR/SOR + Margin rate.

Variable Rate Packages
Variable rate packages are often pegged to a Bank’s “Board rate” or “Housing Rate” or any similar terminology.

For example: -
• Year 1 = “Board Rate 5% - 2.5%” = 2.5% (not fixed)

A bank may at it’s discretion change the “Board Rate” based on it’s own calculation of positive or negative spread within a basket of "loans" pegged to a "Board Rate". Variable rates tend to be cheaper than Fixed rate loans because the bank has the ability to change the rates at any time, thereby reducing their risks. The risks of fluctuation interest rates is passed on to the consumer.

As there were previously some grievances against banks that raise their “Board Rates”. The complaints leveled at banks were that they are not transparent enough as to when to raise the rates. Variable packages which offered a SIBOR or SOR pegged rates become popular.

SIBOR/SOR PEGGED VARIABLE PACKAGES
SIBOR = Singapore Interbank Offered Rate
SOR = Swap offered Rate (SOR is the bank's cost of funds)

What is 1-month Sibor, 3-months Sibor, 6-months Sibor and so on?

These are Fixed deposit rates that the banks offer other banks within the Association of Banks in Singapore (ABS).

Does the rate vary every month? Every 3 months? Every 6 months?

The rates vary daily. The rates changes based on supply and demand of funds available for lending at any point in time within the interbank market. Once a bank takes up a loan, for example SIBOR (1 month) at 1.25%, it is equivalent in lay-man's term to us borrowing a loan that needs to be repayed in 1 month, the interest rate is fixed at 1.25% for 1 month.

So if I sign up to a SIBOR (1 month) for my Home Loan, what does this mean?

For example, your loan is S$1m, when you sign up for a Sibor (1 month) loan for your mortgage, the bank will go to the interbank market to borrow S$1m at the point of disbursement of funds or slightly just before that. If on the day of the disbursement, the rate is 1.29% and the bank charges SIBOR (1 month) + 0.7%, the bank will charge you 1.99% for that 1 month.

Your loan interest rates will be Re-priced every month!

SIBOR/SOR pegged variable packages gives the home owner the transparency. Banks simply offer a “SIBOR + Bank Margin” package.

However there are the 1-month SIBOR rate, the 3-month SIBOR rate and 1-year SIBOR rate packages as well as the equivalent SOR packages.

Example: -
• SIBOR + 0.75%

1-month SIBOR is re-priced every 1 month while a 3-month SIBOR is re-priced every 3 months. This means, your loan repayment quantum changes every month or every 3-months depending on your choice of the peg.

This types of loans are transparent but highly volatile. Because the bank undertakes very little risk, it is usually able to offer the cheapest loan out of the many different possibilities of loans out there.

FIXED AND VARIABLE MIXES
Some banks now offer a variety of Fixed and Variable loans where the home owner is able to specify the percentage of loan to be fixed and variable.


VARIABLE PACKAGE LINKED TO A CURRENT ACCOUNT
This type of mortgage is most useful to businesspeople. They allow a home owner to offset their outstanding loan amount with money deposited in a designated current account linked to the mortgage. This is called Interest offset account.

Example: -
• Mortgage amount for Home is S$800,000.
• But the Home Owner is cash rich and has an emergency fund of S$300,000 which he/she doesn’t need to use, he/she can leave it in the designated account (which he/she can withdraw at anytime).

• Outstanding Mortgage amount = Mortgage amount – Account Balance
• Interest rate = 2%, that means interest cost is S$16,000 (per year) for S$800,000.
• But since the home owner has S$300,000 which he/she doesn’t need to use yet, he/she leaves this S$300,000 in the designated account. The outstanding loan amount is S$500,000, and therefore the interest cost is reduced from S$16,000 --> S$10,000. A saving of S$6,000 while still retaining the financial flexibility.



• Interest rate payment is based on prevailing outstanding balance.


DRAWING MONEY FROM YOUR HOUSE (TERM LOANS)
Most banks will lend you up to 80% and sometimes even 90% of the valuation of your home. Some home owners will suddenly find that their home valuation has gone up. Consequently, the banks are willing to lend you more money.

Example: -
Previous valuation of your property = S$800,000
Mortgage Loan amount @ 80% = S$640,000
Outstanding loan = S$500,000 (An illustration: incl CPF used, eg. 100K)

New valuation of your property = S$1,200,000
Possible Loan amount @ 80% = S$ 960,000
Net Additional Cash borrowings = S$ 960,000 – S$500,000 = S$460,000

For example the interest rate is 2.5%. This is considered very low interest rates because unsecured loans typically cost > 10% in currently.

This money if used carefully is considered the lowest possible rate, which you can use for purchasing another property, pay for your children’s education or travel the world or start a business. Any lower interest rates, you will have to borrow from your parents.

The result of this package is: -

* Mortgage will be S$400,000
* Term Loan will be S$460,000


INTEREST PAYMENT ONLY PACKAGES
Uses either Fixed or float, however the home owner pays only interests and does not pay down the principle. This type of packages are suitable for people who needs the extra cashflow or for investors looking for maximum leverage to boost Return on Invested Capital. This can be a risky proposition in cash flow becomes an issue.
http://www.propertybuyer.com.sg/viewnews.php?article=21

SUPER COMBO PACKAGES
This option involves a Bridging scenario. A home owner staying in his/her existing place (Property A) buying another property (Property B) while trying to sell his existing property.

Property A and Property B involved

* Refinance of Property A to Sibor/SOR package with No redemption penalty, in anticipating of a sale.
* Equity Loan (A term loan tied to property A and B) from Property A to pay for part of downpayment of Property B.
* Property B using Equity Loan from Property A was able to stick within the Loan to valuation (LTV) of smaller or equal 80% and hence enjoys cheaper interest rates.
* Property B borrows 80%, of which 40% is Fixed rates for 3 years and 40% is Sibor/Sor based Floating rate.
* There is also an interest offset current account (Can offset interest against the Variable rate) with a Built-in Over-draft facility.


We have seen more complex cases and we are happy to help you with it.

PENALTY AND LOCK-IN PERIOD
Most banks want to lock you in from typically between 2 years to 5 years. This is because many banks use a step-up interest method where the later year interest rates are higher. Consequently the penalties of breaking the loan at Year 1 may be higher than Year 2.

Example: -
Penalty for full redemption of Loan within year 1 = 2% of outstanding loan amount.
Penalty for full redemption of Loan before year 2 = 1.5% of outstanding loan amount.

LEGAL FEE CLAWBACK
Banks typically offer you legal fee subsidy of 0.4% of loan amount subject to maximum of S$4,000 (for very big loans), but typically S$2,000 (some banks more, some less). In the case of an early redemption (Usually within 3 years), the house owner will be required to pay-back the full legal fees.

Many Property Buyers DO NOT know that they can choose their lawyers. Sometimes they used the given panel of conveyancing lawyers, the rates can be higher. An example, most Condominiums within S$1.5 to S$2m price range, their legal fees should be no more than S$2,000 to S$2,300. Any more, you are over-paying and it will cost you when you refinance.

HOME VALUATON FEE CLAWBACK
Some banks offer free valuation of your property as part of their mortgage loan offers. Other banks offer free valuation of your property provided that you do not redeem your loan within a specified period (Usually 2 years or 3 years). You are most likely required to reimburse the bank at the point of Loan redemption.

The valuation typically cost between S$150 to S$500 for apartments and condominiums, but can cost between of S$1000 to S$10,000 in landed property depending on the land size, property built-up size and terrain.

Some banks give generous VALUATION SUBSIDY, make sure that in case you have a CLAW BACK Clause, push the banks to use your own approved Valuer, because this ultimately comes out from your pocket.

FIRE INSURANCE
There is usually no claw back for fire insurance beyond 1 year of the loan. But it depends on the banks.

MORTGAGE INSURANCE
Most banks do not provide Mortgage insurance in a Home Loan Finance or refinance deal. However some banks have started to cross-sell products from different divisions or re-sell products by insurance companies by putting in a form together with your Home loan package. Mortgage insurance is usually preferred for Joint-Tenancy ownerships. Because in the unfortunate event of the mortality of 1 partner, the partner takes over the assets, but the joint-tenancy partner (Usually a spouse) also take over the debt servicing, if any.

The above is an article provided by www.PropertyBUYER.com.sg