L6 Pre-Sale Transactions

L6 Pre-Sale Transactions - Pre-Sale Transactions HKU Real...

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Unformatted text preview: Pre-Sale Transactions HKU Real Estate Finance K. S. Maurice Tse The University of Hong Kong ktse@econ.hku.hk Introduction Before the crash of the real estate market in 1998 in Hong Kong, the pre-sale market had always been blamed for the sky high property price level which was beyond reach by many who wanted to become property owners. To the investors in the real estate market, presale transaction was a quick way to generate quick returns and profits. Example Consider a residential property on Hong Kong Island called, Illumination Terrace, Tai Hang Rd 5-7, Jardine’s Lookout (Appendix). Example Contd: ILLUMINATION TERRACE (光明台), TAI HANG RD 5-7,JARDINE'S LOOKOUT (渣甸山) Pre-Sale Transactions in Lower Units between May 92 to July 93 Floor 1 1 1 1 1 1 1 1 1 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 3 3 3 3 3 3 3 3 3 3 3 3 Unit E E F F F F F G G C C D D D D F F G G G G H H H C C D D F F F F G G H H Price 2.755 3.25 2.492 2.432 2.62 2.6 2.92 2.473 3.13 3.839 4.49 3.267 3.521 3.73 3.7 2.455 2.591 2.501 2.53 3.152 2.68 2.599 2.77 2.73 3.871 4.1 3.301 3.63 2.291 2.683 2.54 2.6 2.553 2.95 2.662 3.26 G. Area 758 758 696 696 696 696 696 696 696 979 979 903 903 903 903 696 696 696 696 696 696 769 769 769 979 979 903 903 696 696 696 696 696 696 769 769 T. Date 5-May-93 22-Jun-93 29-May-92 6-Jun-92 19-May-93 25-May-93 24-Jun-93 9-May-92 19-Jun-93 18-Jun-92 26-May-93 7-Jul-92 10-Jul-92 18-May-93 5-Dec-93 1-Jun-92 2-Jul-92 8-May-92 20-May-92 19-Apr-93 30-Apr-93 5-May-92 28-May-92 4-Aug-93 4-May-92 5-May-93 8-Jul-92 5-Mar-93 10-Mar-92 7-May-92 7-May-92 4-Mar-93 11-May-92 16-Jun-93 2-Jun-92 6-Aug-93 OP Date 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 # days HP return Day Return 48 16.52% 0.34% 8 347 6 30 -2.44% 7.45% -0.77% 11.61% -0.30% 0.02% -0.13% 0.39% 406 23.56% 0.06% 342 15.66% 0.05% 3 312 201 7.49% 5.77% -0.81% 2.50% 0.02% 0.00% 31 5.39% 0.17% 12 334 11 1.15% 21.98% -16.22% 0.10% 0.07% -1.47% 23 433 6.37% -1.45% 0.28% 0.00% 366 5.75% 0.02% 240 9.50% 0.04% 0 58 301 5.48% 10.32% -3.14% 0.18% -0.01% 401 14.45% 0.04% 430 20.26% 0.05% Example Contd: ILLUMINATION TERRACE (光明台), TAI HANG RD 5-7,JARDINE'S LOOKOUT (渣甸山) Pre-Sale Transactions in Upper Units between May 92 to July 93 Floor 40 40 40 40 40 40 40 40 40 41 41 41 41 42 42 42 42 42 42 42 42 42 42 42 42 42 43 43 43 43 43 43 43 43 43 43 44-45 44-45 44-45 Unit D D E E E E E H H F F G G C C E E F F G G G G G H H A A C C E E E E G G A A A Price 3.704 4.2 2.918 3.158 3.53 3.43 3.968 2.995 3.28 2.656 3.18 3.28 4.1 4.72 5.545 3.173 3.502 2.671 3.05 2.74 2.879 3.268 3.16 3.15 2.769 3.83 4.98 4.5 2.958 4.48 2.933 3.173 3.58 3.28 3.215 3.215 5.163 6.3 6.55 G. Area 910 910 758 769 769 769 769 769 769 696 696 696 769 989 989 769 769 696 696 696 696 696 696 696 769 769 910 910 696 989 769 769 769 769 696 696 1230 1230 1230 T. Date 28-Jan-92 30-Apr-93 5-Mar-92 28-Apr-92 6-Feb-93 13-Apr-93 19-Jun-93 4-Mar-92 25-Mar-93 28-Feb-92 5-Nov-93 20-May-93 29-Jun-93 3-Nov-93 6-Nov-93 29-Apr-92 21-May-93 13-Feb-92 15-Mar-93 7-Mar-92 17-Mar-92 3-Jan-93 4-Feb-93 14-May-93 2-Mar-92 31-May-93 5-Jul-93 3-Dec-93 4-May-92 4-Aug-93 6-Mar-92 30-Apr-92 6-Jan-93 15-Mar-93 26-Apr-93 4-Aug-93 17-Mar-92 24-May-93 6-Oct-93 OP Date 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 93/07 # days HP return Day Return 458 12.57% 0.03% 54 284 66 67 7.90% 11.14% -2.87% 14.57% 0.15% 0.04% -0.04% 0.22% 386 9.09% 0.02% 616 18.01% 0.03% 40 127 3 22.31% 14.08% 16.11% 0.56% 0.11% 5.37% 387 9.87% 0.03% 396 13.27% 0.03% 10 292 32 99 4.95% 12.67% -3.36% -0.32% 0.49% 0.04% -0.11% 0.00% 455 35 151 32.44% 26.26% -10.14% 0.07% 0.75% -0.07% 457 41.51% 0.09% 55 251 68 42 100 7.87% 12.07% -8.75% -2.00% 0.00% 0.14% 0.05% -0.13% -0.05% 0.00% 433 135 19.90% 3.89% 0.05% 0.03% Important Figures The average holding period = 92 days The average holding-period returns = 10.21% The average daily return = 0.187% The annualized average return = 28.48% The return on Hang Seng Index between May 92 and July 93 = 16% The units with the highest average daily return Floor 22 42 2 7 8 23 43 Unit B C D D F A A Price 5.35 5.545 3.521 3.334 3.73 3.83 4.98 G. Area T. Date OP Date 989 6-Oct-93 93/07 989 6-Nov-93 93/07 903 10-Jul-92 93/07 910 10-Mar-92 93/07 696 25-Mar-93 93/07 910 28-Mar-93 93/07 910 5-Jul-93 93/07 # days 1 3 3 4 26 37 35 HP return 6.77% 16.11% 7.49% 7.08% 36.48% 33.13% 26.26% Day Return 6.77% 5.37% 2.50% 1.77% 1.40% 0.90% 0.75% Introduction Contd In 1995, the Hong Kong Government said, “Pre-sale market is the hotbed of speculative activities in the real estate market.” Since then the Government had been using the pre-sale market as a tool to control the speculative transactions in and hence the price level of the property market. For example, in 1995, the Government essentially prohibited pre-sale market transactions. We saw the plunge in the supply of residential real estate. After the Asian financial crisis broke out, the property price in Hong Kong fell by as much as 70 percent. And the HKSAR Government began to relax the restrictions on pre-sale transactions with the hope to revive the level of transactions in the property market. Introduction Function of P re-sale M arket to Real Estate Developer Questions: What’s the use of the pre-sale market to the developer?? What’s the effect of pre-sale transaction on the real estate supply?? From what happens in the pre-sale market, what can we say about developers’ view on the future real estate prices?? Supply decision of the real estate developers ?? Supply quantity ?? Pre-sale quantity ?? Supply quantity (q)? Sell the rest of the units (q-h). How many units (h) to pre-sell? Price is unknown at t = 0 Pre-sale Price known (pf) Start of Construction Today t = 0 End of Construction Analysis Sell h units in the presale market at fixed price pf today Sell the rest (q - h) at the unknown spot market price at the end of construction. Current & Projected Market Conditions affect the presale market price pf . Pre-sale revenue: Can be invested in other projects Can pay off existing debts (Cost savings) Future spot price upon completion of construction is ~ uncertain and is represented by p Developer is risk-averse. Analysis: Developer’s Profit Profit Function q = number of units to build. h = number of units to pre-sell C (q) = variable cost with: C ’(q) > 0 and C ”(q) > 0. Assume C(q) = c/2 * q2 for simplicity. B = the fixed costs of development Analysis: Profit Contd What is the developer’s profit? ~ = ????? π 1st term = presale revenue 2nd term = $ return on the use of presale revenue (use = α%) 3rd term = sales revenue by selling the remaining units at the end of the construction period 4th term = Variable Cost 5th term = Fixed Cost Price Risk (profit risk)??? ~ = p h + α ( p h) r + ~ ( q − h) − c q 2 − B π p f f 2 Analysis: Price Risk (profit risk) p Uncertain future price : ~ Uncertain profit function Must forecast the future spot price. Forecasting uncertain future spot price (unbiased): ~ = p +ε p p : expected (mean) future spot price ε : forecast error with E(ε) = 0 and Var(ε) = σp2. p p E(~ ) = p and Var(~) = σp2. Variance term (σp2) = price risk faced by the developer. Analysis: Profit Risk Contd Profit with Price Risk ~ Expected profit E(π ) to the developer ?? ~ ) = ??? E (π ~ Variance of profits Var(π ) to the developer?? ~ ) = ??? Var (π Question: I f the governm ent prohibits pre-sale transactions in the real estate m ark et, how w ould the profit risk affect the supply decision of the developers?? Analysis: Effect of Risk-Aversion Developer is risk averse. Since they are risk averse, they will be conservative when making development decision based on the projected profit. Developer will not choose q and h just to maximize expected profit. Developer will maximize the certainty-equivalent profit. What is certainty-equivalent?? Concept?? Concept of Certainty Equivalent Certainty Equivalent is the amount of money the developer is willing to take in order to avoid taking the profit risk. Example: Fire Insurance A property is worth $5m. In case of a fire, value destroyed is $1.8m on average. Fire insurance = $0.5m $3.2m Fire Fire No Insurance No fire $5m- 0.5m =4.5m $5m Insurance No fire $4.5m $4.5m can be regarded as the certainty equivalent of the property owner. Concept of Certainty Equivalent How much insurance the property owner wants to buy depends on his/her degree of risk aversion. The more risk aversion, more insurance, hence the smaller the certainty equivalent. The amount of insurance purchased will also depends on the probability of fire risk (or the variance of his/her net wealth after risk) $3.2m Fire Fire No Insurance No fire $5m- 0.5m =4.5m $5m Insurance No fire $4.5m Certainty Equivalent of Profit The amount of profit the developer is willing to give up to avoid risk can be described by the following picture ??? Variance Mean Profit λ/2 = trade-off at equilibrium between expected profit and variance of profit. Certainty Equivalent of Profit Contd Developer will choose the scale of development (q) and the presale quantity (h) to maximize the certainty-equivalent profit (πCE) which is given by?? ??? Another way to describe this certainty equivalent of profit is that the developer, because of his risk aversion, will only make decision based on a more conservative forecast of future profit. Certainty Equivalent of Profit Contd Recall ~ ) = p h + α ( p h) r + p ( q − h) − c q 2 − B E (π f f 2 ~ Var (π ) = (q − h) 2 σ 2 p π CE ~ ) − λ Var (π ) ~ = E (π 2 Hence π CE = ??? Objective of the developer Maximize the certaintyequivalent profit by choosing the optimal q and h. Optimal Decision by Developer The corresponding first order conditions are: ∂π CE 2 = p − cq − λ (q − h)σ p = 0 ∂q ∂π CE 2 = p f + αrp f − p + λ (q − h)σ p = 0 ∂h The solution for optimal supply of units of property (q*) is found by adding the two equations together: p f + αrp f − cq = 0 ⇒ q = * p f (1 + αr ) c Implications of Pre-Sale Market Supply of space depends only on pre-sale price variable cost use of pre-sale revenue opportunity cost of pre-sale revenue Price risk can be eliminated by hedging (pre-selling some units). The production decision is made as if the firm was in a risk-free environment. Developer should produce until the marginal variable cost equals the price per unit of space in the pre-sale market and the corresponding reinvestment return. What if Pre-Sale Market Does Not Exist ????? If pre-sale market does not exist, h = 0. Optimal supply of real estate from the first order condition with respect to the supply quantity q is: ∂π CE 2 = p − cq − λ (q − h)σ p = 0 ∂q ??? Optimal supply decision depends on: Expected future spot price Variable Cost Price risk Developer’s degree of risk aversion Implications of Prohibiting Pre-Sale Transactions The higher the price risk, the lower the supply quantity. The more risk averse the developer is, the lower the supply quantity. Comparing q’ (without pre-sale) with q* (with pre-sale) allows us to see that at each price level, the supply of real estate is higher with pre-sale transactions than without Price 0 q’ q* Supply Quantity Statement about Pre-Sale Transaction The existence of pre-sale market that allows the developer to transfer price risk to the buyers induces the developer to produce more because the developer is not paying risk costs along with other production costs. What About the Pre-Sale Quantity ???? From the first order condition ∂πCE/∂h = 0 above, we can solve for the optimal pre-sale quantity h*: h = ??? * I m plications: I f p = p f (1 + α r), total output of space q * will be pre-sold. A risk averse developer will exchange an uncertain price for a certain one if the latter equals the expected value of the uncertain one. However, the expected and the actual future spot price may not be equal. Implications Contd Risk averse developers will exchange a certain price pf for the uncertain spot price only if the expected spot price includes a risk premium. That is, p > p f (1 + α r) Consider the case when p > pf (1 + α r) Now q* must exceed h* and the firm will hedge some of its space output. The developer sells part of the output at the forward price pf and sells the rest upon completion for the uncertain spot price. The more risk-averse the developer, the greater the level of hedging for the same positive price difference between p and pf. Implications Contd Question for Discussion: What can we say about the effect of the following factors on the pre-sale quantity?? The developer’s need for fund (α) The opportunity cost faced by the developer (r) Expected future spot price (p) Risk aversion factor (λ) Property price risk (σ) ...
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