Department of Real Estate DRE Centre for

Department of Real Estate (DRE) & Centre for Financial Engineering (CFE) Joint Executive Program on Real Estate Securitization & Financial Innovations Asset Backed Securitization in Singapore: Value of Embedded Buy-back Options Dr Sing Tien Foo Department of Real Estate National University of Singapore 27 July 2001 Email: rststf@nus. edu. sg Dr Sing Tien Foo

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 Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

Real Estate Secondary Markets Characteristics 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. Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

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 Singapore Mortgage Backed Bond (MBB) Property Funds (Real Estate Investment Trusts REITs) Asset/Property Backed Bonds/ Securities Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

Asset-Backed Securitization in Singapore What is Asset-Backed Securitization (ABS)? A creative financing arrangement Structure of asset-backed securitization Embedded options in the deals First transaction: Neptune Orient Building, Alexander Road 7 commercial properties have been securitized with net asset value of $2. 8045 billion Significance of the Option Values Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

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 (Capita. Land) $984. 5 mil. Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

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 shares Securitization is an open market selling of financial instrument backed by asset cash flow or asset value A 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 Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

Types of Securitized Asset in US Loans Leases n. Car loans n. Vehicle n. Commercial leases property n. Equipment Receivables n. Credit card Others n. Subsidies n. Royalty receivables n. Trade receivables income loans leases n. Phone bill n. Ticket n. Bank loans n. Aircraft receivable income n. Project loans leases n. Utilities receivables n. Tuition/ n. Train leases n. Toll free receivables student loans n. Ship leases n. Insurance n. Bad loans n. Share leases receivables n. Mail order receivables Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

Why Securitized? Lower-cost financing In Singapore, the cost of debt is relatively low Liquidity crunches? Equity saving Leverage restrictions Reduction of assets – create liquidity to the company Matched funding / funding strategy Earnings Originator capitalizes the future cash flow Growing significance as an alternative financing method Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

Structure of Securitization Distinguished from mortgage-backed or collateralized loan Off-the-balance-sheet sale of property at open market value Special purpose vehicle (SPV) created as a trustee to facilitate the pay-through of receivable to the investor Investors are insulated against bankruptcy risks of originator Improve transparency and enhance credit rating of security issues Fixed rate bonds - pay-through structure Claim on rental flow and partial share of price appreciation Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

Securitization Process Open market valuation of property to be securitized Off-the-balance-sheet transfer of ownership rights to the SPV – an enbloc sales Embedded 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 shares Fixed coupon payment to investors from rental & other revenues generated from the building Partial sharing of capital appreciation if option is exercised within the maturity period Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

Schematic Diagrams of ABS Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

Parties in Securitization (I): Originator A company or an organization that has assets generating cash flows which are used as payment of securities Sell assets to a special purpose vehicle (SPV) or a trustee to remove the assets from its balance sheet Off-balance-sheet securitization vs on-balance sheet securitization Involves in collection of payments of the assets & passing of payments to the SPV at fees Off-balance-sheet – legal costs in conveying assets to SPV Credit risks of originator are insulated/separated On-balance-sheet – Lionie Condotel Bond Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

Parties in securitization (II): SPV Purchase assets or receivables from the originator Create “bankruptcy remote” structure Protect ABS investors against the default of originator Higher credit rating for the issuing securities Two types of structure for SPV Pass-through Pay-through Depending on nature of receivable & funding requirement of originator Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

Parties in Securitization (III): Underwritter & Investors Underwritter bridges cash flows between investors and originators Roles of underwritter Indetification of securitization structure Pricing of issues Placement capacity – optimal issuance size Investors – insurance companies, pension funds, mutual funds and hedge funds Attraction of ABS to investors High credit quality High yield Liquidity Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

Potential Benefits/Motivations To owner/originator Alternative financing instruments Improve liquidity in the balance sheet Reinvestment and freeing up the low-yield assets Transfer the interest rate risks to SPV To bondholders/investors New Investment opportunities for diversification Direct participation in real estate market by small investors Partial sharing of future capital gain through preference shares Building as collateral To Real Estate Market An active secondary capital market for institutional investment Alternative Financing Options Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

Why Securitization? In US, rising cost of originating loan and tight liquidity in debt market In Singapore, different motivation driving the securitization market Liberalization and depleting of liquidity in debt market Alternative source of financing at attractive terms Reducing corporate gearing Diversifying financing risks Protected against floating rate risks when term structure of interest rates is volatile Low rental yield of holding property Re-investment return & improve efficiency of capital Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

Attractive Yields ABS bond yields: 5. 5% to 6. 75% JTC and HDB fixed coupon bond yields : 3. 875% to 5. 0% Based URA’s office index (Q 178 -Q 399), 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 originator ABS investors have priority on the assets in the case of financial distress ABS is backed by securitized property Lower risk & tradability of the ABS bonds Lower transaction fees compared with direct sale of Dr Sing Tien Foo property Real Estate Securitization & Financial Innovations

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 Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

Real Estate Holdings Pte Ltd (wholly owned subsidiary of DBS Land) A Put Options to sell back property at a strike price equivalent to original price plus 35% of capital appreciation Embedded Options in a typical Securitization deal Originates the securitization Process Baronet Limited (Special Purpose Vehicle) 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%) Birchvest Investments Pte Ltd (wholly owned subsidiary of DBS Land) An option to lease back the Property for 10 -year Investors Share of certain percentage of the capital Appreciation, when the call/put options are exercised Rental and other income equivalent to or exceed interest payments to bondhodlers RE Properties Pre Ltd 268 Orchard Road Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

Pricing Embedded Options Option Pricing Theory Case Illustration – 268 Robinson Point Theoretical Framework Binomial Option Pricing Methdology Estimation Results Sensitivity Analysis Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

Case Illustration 268 Orchard Road – 10 year bond issues Explicit 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 bondholders Call options can only be exercised after three years Exercised 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) Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

Theoretical Framework Binomial Tree Option Pricing Model Discrete Price Change – by u and d Risk-neutral probability p Determining the strike price Percentage sharing of the capital appreciation Payoff function Difference between market and strike prices Option types Option formulas Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

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. 15 Price movement follow a binomial tree as follows ($9. 00) and q =0. 5 ($8. 15) ($7. 00) and 1 -q =0. 5 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. 704 Option premium =($0. 50 *0. 704)/(1. 05) = $0. 34 Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

Option Formulas European Options, EC(T 1, 0, 0, PS 1) = American Options, AC (Tk+1, Tk, n, 0, PSk) = Compound Options Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

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 3 rd year 25% European Call From the first day of the 4 th year to the last day of the 5 th year t=4 to t=5 25% American Call From the first day of the 6 th year to the last day 7 th year t=6 to t =7 30% American Call From the first day of the 8 th year to the last day of the 9. 5 th year t=0 to t=3 t=8 to t =9. 5 35% American Call From the first day of the 9. 6 th year to the 30 th day after the maturity of the bonds t=9. 6 to t=10. 08 35% American Put Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

Estimation Results Securitization of 268 Orchard Road Input parameters/assumptions Unit Price (P) = $1, 392 per net floor area Risk free rate (rf) = 5% p. a. Price volatility (s) = 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) Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

e at e. R re -F isk R Option Premium Sensitivity of Option Premiums ility t Price Vola Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

Tax Implications Have these embedded options been priced in the open market valuation? Stamp duty At the date of transaction When the options are exercised Moral Hazard problem Property tax valuation for comparable buildings Lease back options at guaranteed rental income Hypothetical Annual Value estimation when market rental is higher? Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

Effects on Risk Structure Are bondholders subsidizing the originator by giving the options worth $28. 5 million free? Lemon Market – negative signals JTC 10 year fixed rate bond yields 4. 75% to 5. 00% Asset-backed securitization 5. 50% to 7. 00% Put option agreement Mainly to facilitate the transfer of the ownership back to the originator Redundant in an upmarket Retention of major share by the originator via Junior bond tranches? Moral hazard Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

Market Impact Potential and Importance of Asset-Backed Securitization in Singapore Developers should better utilize capital in development activities than locking-in the capital in low-yield prime properties Rejecting of productive capital into real estate market Investors are open to more avenue to diversify into property market Practical and institutional problems Valuation of embedded options Impact on Property Taxation and Efficiency of Market Asymmetry of Information Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

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 Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

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. Dr Sing Tien Foo Real Estate Securitization & Financial Innovations

End of Presentation Thank you Presentation slides are available at my homepage: http: //www. sde. nus. edu. sg/~rststf/ Click “My ECA” and then “Others” ECA Others Dr Sing Tien Foo