Optionality in Presale of Real Estate Developments

1. Optionality in Presale of Real Estate Developments Sergio Rozenbaum, Luiz Brandão, Alexandre Rebello and Graziela Fortunato 12th Annual International Conference on Real Options Rio de Janeiro, July 2008

2. Introduction: Problem • Presale of Real Estate units: Sale before completion • Reasons: • Risk sharing • To reduce liquidity risk • For the investor: locks in the property price • Risks involved: • Demand uncertainty • Price Volatility • Long turnaround time and low liquidity • Investor Default

3. Introduction: Problem • Asia: • Developers must complete a portion prior to presale • Risk of receiving an inferior product tends to favor established developers and market concentration. • Investor is penalized for default • Brazil • Full project spec files with authorities prior to presale, reducing the risk to investor • 50% received during construction and the rest upon delivery • Investors in default are taking developers to court

4. Introduction: Problem • The case of Brazil • Prior to 1990, investors forfeited all prior payments in case of default • Consumer protection laws of 1990 required partial refund, but developers capped refunds at 15% to 20% of amounts paid. • Some investors have been able to receive up to 90% refund by suing developers in court • Recent court rulings have established that developers must a minimum of 70% of amounts received. • This had the effect of establishing by law a strike price for the option to abandon a presale contract, creating an lawful abandon option for the investor. .

5. Introduction: Objective • To determine the value and incremental cost of this abandon option to a real estate developer • To determine the impact on real estate investment strategies. • The option to abandon is modeled as American Put with exercise period of 24 months, which is equal to the construction period.

6. Model and Assumptions • Price Model Where: V is the market price of the property; dz is the Wiener increment; μ is the expected growth in the property’s value • is the volatility of the property value. • Option and Solution • American Put Option • Solved with 24 period discrete binomial CCR model

7. Model and Assumptions • Investor: • Presale Purchase at time t = 0 • 50% total price paid during 24 month construction period as follows: • 10% down payment at t = 0 • 4 semi annual payments of 4% at t = 6, 12, 18 and 24 • 24 monthly payments of 1% of total price. • 50% refinanced upon completion and delivery of unit. • Exposed to price volatility risk • Will exercise option to abandon if market value at t = 24 drops below the balance still to be paid plus the amount to be refunded.

8. Price Volatility • Historical prices series of residential property (Secovi-RJ) • Period: Jan/95 – Dec/05 • Interval: Monthly basis • Real values • Area: Neighborhoods of Greater Rio • Type: Studio, one, two, three and four bedrooms

10. Price Volatility

11. Model and Assumptions • Models for First and Second Periods • If investor chooses to enter into presale contract, he is required to make first down payment P0.

12. Model and Assumptions • Partial View of Project Model

13. Model and Assumptions • Model of Periods 23 and 24 • Continuation required further down payment installments • Abandon entails receiving a portion d of accumulated payments gi up to period i.

14. Partial View of Tree

15. Percentage of Refund Size Volatility 0% 10% 30% 50% 70% 90% Studio 11.34% 5.1% 6.0% 7.8% 10.2% 12.7% 15.9% 1 Room 11.30% 5.1% 5.9% 7.8% 10.1% 12.6% 15.8% 2 Rooms 9.30% 3.2% 3.8% 5.5% 7.4% 9.7% 12.7% 3 Rooms 9.24% 3.2% 3.8% 5.4% 7.3% 9.6% 12.6% 4 Rooms 8.70% 2.7% 3.3% 4.8% 6.6% 8.8% 11.7% Results • Option Value as function of region in % of property price • Option Value as function of size in % of property price

16. Results • Option Value as function of region in and unit size (as % of property price 4 Rooms Region 18 3 Rooms Region 11 2 Rooms Region 9 1 Room Region 7 Studio Region 1 0% 10% 30% 50% 70% 90% 0% 10% 30% 50% 70% 90% % of refund % of refund

17. Conclusion • The value of the option to abandon is high and can have a significant impact on the profitability of a real estate developer • For the average neighborhood of Rio, the option value for a refund rate of 70% was close to 10% of the value of the property. • This implies that the presale system may not reduce the risk to the developers as much as before • Developers may be saddled with illiquid property if there is a strong downturn in the market at the same time they may be called upon to refund investors as they exercise their option to abandon this unprofitable investment.

18. Conclusion • For developers, this information may allow them to mitigate their risks by offering alternatives that increase the option exercise cost to the investor, such as product customization • For the investor, this information is also valuable since it allows him to make optimal decisions and negotiate better conditions with the developers if necessary. • Model limitations includes low reliability of volatility estimates since price series refer to different properties due to lack of public records of real estate transactions.

19. O GLOBO 04/02/2009 A venda de apartamentos em lançamentos imobiliários, em uma época de grande turbulência financeira, é um risco muito grande para o incorpora-or. A inclusão da decoração pode ser uma ação de marketing,mas também pode ter sido adotada como proteção a uma futura devolução. “De posse dessa informação, uma das alternativas para estes incorporadores possivelmente poderia ser o de criar condições que tornem a opção de abandono menos atrativa, através da oferta de customização do imóvel ou a inclusão de produtos específicos de maior valor agregado como cozinhas e armários planejados, cujos custos não são passiveis de devolução no caso de desistência.” Texto do artigo.

20. Optionality in Presale of Real Estate Developments Sergio Rozenbaum, Luiz Brandão, Alexandre Rebello and Graziela Fortunato 12th Annual International Conference on Real Options Rio de Janeiro, July 2008