Asset Backed Securitization in Singapore: Value of Embedded Buy-back Options Department of Real...

Asset Backed Securitization in Singapore: Value of Embedded Buy-back Options

Department of Real Estate (DRE) & Centre for Financial Engineering (CFE)Joint Executive Program on

Real Estate Securitization & Financial Innovations

Dr Sing Tien Foo

Department of Real Estate

National University of Singapore

27 July 2001

Email: [email protected]

Dr Sing Tien FooReal Estate Securitization & Financial Innovations

Lecture Outline

Development of real estate securitization market in Singapore

Asset backed securitization in Singapore

Securitization structure and process

Potential benefits & investment motivations

Embedded options and their pricing implications

Pricing the embedded options

Effects of embedded options on the risk structure

Market impact & conclusion


Real Estate Secondary MarketsCharacteristics of real estate investment: lumpy, illiquid, large capital outlays Real estate equity market is an active secondary real estate investment in Singapore Development in secondary real estate market

In UK: Single Asset Property Company (SAPCO), Single Property Ownership Trusts (SPOT), Property Income Certificate (PINCs)In US: Real Estate Investment Trusts (REITs), Mortgage backed securities (MBSs)In Australia: Listed and unlisted property trusts

Property related securitization surfaced in Singapore in 1986 with the first mortgage backed bond (MBB) on Hong Leong Building.


Development of Securitization Market in Singapore

Capital market in Singapore

Development of bond market has been slow and dominated by government bonds

In 1993 bond market share is 56.3%, and it drops to 46% in 1999. The value of bond issues has however increased from S$171 billion to S$327 billion

Three vehicle for securitizing real estate in SingaporeMortgage Backed Bond (MBB)

Property Funds (Real Estate Investment Trusts REITs)

Asset/Property Backed Bonds/ Securities


Asset-Backed Securitization in Singapore

What is Asset-Backed Securitization (ABS)?A creative financing arrangementStructure of asset-backed securitizationEmbedded options in the dealsFirst transaction: Neptune Orient Building, Alexander Road7 commercial properties have been securitized with net asset value of $2.8045 billionSignificance of the Option Values


Recent Asset-Backed Securitization Deals in Singapore

Issue

Date

Property Owner Market Value

Mar 99 Neptune Orient Line HQ NOL $185 mil.

Jun 99 Century Square Shopping Mall

First Capital Corporation

$200 mil.

Jul 99 Robinson Point DBS Land $193 mil.

Sep 99 268 Orchard Road DBS Land $184 mil.

Nov 99 Tampines Centre DBS Land $180 mil.

Nov 99 Six Battery Road DBS Land $878 mil.

June 01 Raffles City Raffles Holding (CapitaLand)

$984.5 mil.


What is Asset-backed Securitization?

Securitization is a process of turning equity interest in real estate, which is illiquid and lumpy, into tradable securities such as bonds and sharesSecuritization is an open market selling of financial instrument backed by asset cash flow or asset valueA contractual arrangement whereby real estate owners sell their real estate asset(s) to a special purpose vehicle (SPV) SPV issues debt instruments (bonds) to finance the purchase Structure of SPV

Pass-through vs. Pay-through instrument


Types of Securitized Asset in USLoans Leases Receivables Others

Car loansCommercial property loansBank loansProject loansTuition/ student loansBad loans

Vehicle leasesEquipment leasesAircraft leasesTrain leasesShip leasesShare leases

Credit card receivablesTrade receivablesPhone bill receivableUtilities receivablesToll free receivablesInsurance receivablesMail order receivables

SubsidiesRoyalty incomeTicket income


Why Securitized?

Lower-cost financingIn Singapore, the cost of debt is relatively lowLiquidity crunches?

Equity savingLeverage restrictionsReduction of assets – create liquidity to the company

Matched funding / funding strategyEarnings

Originator capitalizes the future cash flow

Growing significance as an alternative financing Growing significance as an alternative financing methodmethod


Structure of SecuritizationDistinguished from mortgage-backed or collateralized loanOff-the-balance-sheet sale of property at open market valueSpecial purpose vehicle (SPV) created as a trustee to facilitate the pay-through of receivable to the investorInvestors are insulated against bankruptcy risks of originatorImprove transparency and enhance credit rating of security issuesFixed rate bonds - pay-through structureClaim on rental flow and partial share of price appreciation


Securitization ProcessOpen market valuation of property to be securitized Off-the-balance-sheet transfer of ownership rights to the SPV – an enbloc salesEmbedded options:

Lease back option Buy-back option (65-75% off market value)Put-option to sell back property to originator

SPV finances the purchase by issuing secondary market instruments: bonds and preferential sharesFixed coupon payment to investors from rental & other revenues generated from the buildingPartial sharing of capital appreciation if option is exercised within the maturity period


InvestorsInvestors

(Purchasing (Purchasing ABS bonds ABS bonds

for fixed for fixed returns)returns)

Originator Originator (Company (Company securitizingsecuritizing

its real its real estate)estate)

Special Purchase

Vehicle (SPV)

Investments in secondary market

instrument

Rental Cash Flow received from the securitized real

estate leases

Sale Proceeds from the sale of

securitized real estate

Bond/ Dividend Yield

Real Estate Market

Secondary Market

Lease-back option

Buy-back option

Exchange of cash flows between originator and investors via SPV

Transfer of embedded options

Boundaries between primary and secondary markets

Notes:

Source: The Authors

Schematic Diagrams of ABS


Parties in Securitization (I): Originator

A company or an organization that has assets generating cash flows which are used as payment of securitiesSell assets to a special purpose vehicle (SPV) or a trustee to remove the assets from its balance sheetOff-balance-sheet securitization vs on-balance sheet securitizationInvolves in collection of payments of the assets & passing of payments to the SPV at feesOff-balance-sheet – legal costs in conveying assets to SPV Credit risks of originator are insulated/separatedOn-balance-sheet – Lionie Condotel Bond


Parties in securitization (II): SPV

Purchase assets or receivables from the originatorCreate “bankruptcy remote” structureProtect ABS investors against the default of originatorHigher credit rating for the issuing securitiesTwo types of structure for SPV

Pass-throughPay-through

Depending on nature of receivable & funding requirement of originator


Parties in Securitization (III): Underwritter & Investors

Underwritter bridges cash flows between investors and originatorsRoles of underwritter

Indetification of securitization structure Pricing of issuesPlacement capacity – optimal issuance size

Investors – insurance companies, pension funds, mutual funds and hedge fundsAttraction of ABS to investors

High credit qualityHigh yieldLiquidity


Potential Benefits/MotivationsTo owner/originator

Alternative financing instrumentsImprove liquidity in the balance sheetReinvestment and freeing up the low-yield assetsTransfer the interest rate risks to SPV

To bondholders/investorsNew Investment opportunities for diversificationDirect participation in real estate market by small investorsPartial sharing of future capital gain through preference sharesBuilding as collateral

To Real Estate Market An active secondary capital market for institutional investmentAlternative Financing Options


Why Securitization? In US, rising cost of originating loan and tight liquidity in debt marketIn Singapore, different motivation driving the securitization marketLiberalization and depleting of liquidity in debt marketAlternative source of financing at attractive termsReducing corporate gearing Diversifying financing risksProtected against floating rate risks when term structure of interest rates is volatileLow rental yield of holding propertyRe-investment return & improve efficiency of capital


Attractive YieldsABS bond yields: 5.5% to 6.75% JTC and HDB fixed coupon bond yields : 3.875% to 5.0%Based URA’s office index (Q178-Q399), annualized growth rate of 9.88%Share of capital appreciation 30%*9.88% = 2.96%Compared to equity holder, ABS investors are protected against credit and financial liability of originatorABS investors have priority on the assets in the case of financial distressABS is backed by securitized propertyLower risk & tradability of the ABS bonds Lower transaction fees compared with direct sale of property


Embedded Options

Sale & Leaseback Option

Call Option for vendor to buy back property

Put Option for SPV to sell back property

Equity participation in capital appreciation for mortgage-backed bond holders.

Embedded options in 268 Orchard Road Securitization


Embedded Options in a Embedded Options in a typical Securitization dealtypical Securitization deal

Baronet Limited(Special Purpose Vehicle)

RE Properties Pre Ltd

268 Orchard Road

Birchvest Investments

Pte Ltd(wholly owned subsidiary

of DBS Land)

Investors

A Put Options to sell back property at a strike price equivalent to original price plus 35% of capital appreciation

A Call Option to buy-back the Property at an exercise price, equivalent to original sale Price plus a percentage of capital appreciation (25%-35%)

An option to lease back the Property for

10-year

Rental and other income equivalent to or exceed interest payments to bondhodlers

Share of certain percentage of the capital Appreciation, when the

call/put options are exercised

Real Estate Holdings Pte Ltd

(wholly owned subsidiary of DBS Land) Originates the securitization Process


Pricing Embedded Options

Option Pricing Theory

Case Illustration – 268 Robinson Point

Theoretical FrameworkBinomial Option Pricing Methdology

Estimation Results

Sensitivity Analysis


Case Illustration268 Orchard Road – 10 year bond issuesExplicit call option agreements

Upon exercised, entitle the owner to re-possess the building from the SPV at the original issue price, plus % of capital appreciation to be distributed to bondholdersCall options can only be exercised after three yearsExercised anytime from year four to year 9.5 year

Put option If exercised, requires the owner to buy back the building from the SPV at original issue price% Capital appreciation sharing = 35% (redundant)


Theoretical Framework

Binomial Tree Option Pricing ModelDiscrete Price Change – by u and d Risk-neutral probability p Determining the strike price

Percentage sharing of the capital appreciation

Payoff functionDifference between market and strike prices

Option typesOption formulas


Option Pricing Analogy

Let say an call option is underwritten on a unit of City Development Limited (CDL) share at an exercise price of $8.50 exercisable only in a year time.Current CDL share price is S$8.15Price movement follow a binomial tree as follows

At risk free rate of 5%, risk neutral probability is computed as p= [(1+0.05)*$8.15-$7.00]/($9.00 - $7.00) = 0.704Option premium =($0.50 *0.704)/(1.05) = $0.34

Pt

Pt+dt = dPt

Pt+dt = uPtq

1-q

($9.00) and q =0.5

($7.00) and 1-q =0.5

($8.15)


Option Formulas

European Options, EC(T1,0, 0, PS1) =

American Options, AC (Tk+1, Tk, n, 0, PSk) =

Compound Options

rndtn

jtt

jnjjnj eSduPMaxppjnj

n

*)0,()1(

)!(!

!

0,

)(0

)(

n

i

in

jt

rdtt

jinjk ejinCpjinpCSduPMax

1 0,0, *),1,()1()1,1,(,

idtTr

iiikN EePSTTACEPSTECMaxPSTCO i

)/(1011 *),,(,),0,(),0,(


Characteristics of Embedded Options

The date of exercising the call option % Share of capital

appreciation

Type of Option

From the date of origination to the last day of the 3rd year

t=0 to t=3 25% European Call

From the first day of the 4th year to the last day of the 5th year

t=4 to t=5 25% American Call

From the first day of the 6th year to the last day 7th year

t=6 to t =7 30% American Call

From the first day of the 8th year to the last day of the 9.5th year

t=8 to t =9.5

35% American Call

From the first day of the 9.6th year to the 30th day after the maturity of the bonds

t=9.6 to t=10.08

35% American Put


Estimation Results

Securitization of 268 Orchard Road

Input parameters/assumptionsUnit Price (P) = $1,392 per net floor area

Risk free rate (rf) = 5% p.a.

Price volatility () = 20%

Growth rate (g) = 2.0%

Frequency of adjustment (dt) = 0.25 (quarterly)

Premium of embedded options:

$33 million or equivalent of $250.36 per sf.

Approx. 18% of total bond value ($184 million)


8%

12

%

16

%

20

%

24

%

28

%

32

%

2%

4%

6%8%

100

150

200

250

300

350

400

450

Price Volatility

Risk-Free Rate

Op

tion

Pre

miu

m

Sensitivity of Option Premiums


Tax Implications

Have these embedded options been priced in the open market valuation?Stamp duty

At the date of transactionWhen the options are exercisedMoral Hazard problem

Property tax valuation for comparable buildingsLease back options at guaranteed rental incomeHypothetical Annual Value estimation when market rental is higher?


Effects on Risk Structure

Are bondholders subsidizing the originator by giving the options worth $28.5million free?Lemon Market – negative signals

JTC 10year fixed rate bond yields 4.75% to 5.00%Asset-backed securitization 5.50% to 7.00%

Put option agreementMainly to facilitate the transfer of the ownership back to the originatorRedundant in an upmarket

Retention of major share by the originator via Junior bond tranches? Moral hazard


Market ImpactPotential and Importance of Asset-Backed Securitization in SingaporeDevelopers should better utilize capital in development activities than locking-in the capital in low-yield prime propertiesRejecting of productive capital into real estate marketInvestors are open to more avenue to diversify into property marketPractical and institutional problemsValuation of embedded optionsImpact on Property Taxation and Efficiency of MarketAsymmetry of Information


Conclusion

Securitization would be an important financing instrument when interest rate is more volatile

Transparent and fair valuation of securitizatin deal is important

Contributing to the efficient pricing and structuring of future securitization deals

Advancing the valuation and pricing techniques that are applicable for the asset securitization


References:

Kendall, Leon T., “Securitization: A New Era in American Finance, in Kendall, Leon T.and Fishman, Michael J. (eds.) A Primer on Securitization, 1996, pp 11-16.*Ong, Seow Eng, Ooi, Joseph and Sing, Tien Foo, (2000) “Asset Securitization in Singapore: A Tale of Three Vehicles,” Real Estate Finance, Summer 2000, pp 47-56.Sing, Tien Foo, (December 2000), “Opening New Doors,” Property Review, December 2000. Sing, Tien Foo and Ong, Seow Eng, (1999) “Valuing Asset Backed Securitization Transactions,” NUS-CRES working paper #CRES:1999-017.

End of Presentation

Thank you

Presentation slides are available at my homepage: http://www.sde.nus.edu.sg/~rststf/Click “My ECAMy ECA” and then “OthersOthers”

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Asset Backed Securitization in Singapore: Value of Embedded Buy-back Options Department of Real...

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