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Article Excerpt
The paper examines the risk-and-return characteristics of a popular development strategy, the presale system (or sale before completion), used in many Asian cities. We model a presale decision in a real-options framework and suggest that the use of presale is primarily for a risk-sharing purpose. That is, developers can reduce bankruptcy and marketing risks by selling (or leasing) their projects before their completion dates. Our model also indicates that, because of the presale system, there is a barrier for new developers to enter into a market, which helps explain the anecdotal observation that most real estate markets in Asian cities are oligopolistic in nature and dominated by large developers.
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Developers have to start construction based on a projected future demand and take the risk that the demand might not be realized when the projects are completed. Developers will be in a difficult financial position (holding vacant buildings and construction loans that are waiting to be paid off) if demand has unexpectedly fallen at the time of completion. Limiting the costs of such an outcome is important to the viability of developers.
An examination of the practices of development communities around the world indicates that there are at least three methods to deal with the risk associated with demand uncertainty. First, developers may delay the property development until they are more confident about the future demand. The seminal work by Titman (1985) explicitly models the value of this "option to wait" in the project investment process. Somerville (2001) also concludes that builders will obtain building permits first, but will only exercise them after the demand conditions become clearer. Quigg (1993), Bulan, Mayer and Somerville (2002) and Schwartz and Torous (2003) all provide empirical evidence that supports the "option to wait" theory.
While the first method deals with the identification of the demand curve, the second method is a strategy that works with the demand curve. This method is popular when developers have a multiphase project. If the state of the market is unclear when the development starts, a risk-averse developer might reduce the price on the earlier units to ensure that there will be sufficient demand for the product. Developers can increase the price level of the remaining phases if future demand conditions warrant it.
The use of this method has some empirical support. For example, Sirmans, Turnbull and Dombrow (1997) document that developers would be willing to sell the units in the earlier phases of a subdivision at a lower price because of the uncertainty about the future characteristics of the neighborhood. They will sequentially increase the price of the units in the later phases of the subdivision as more (positive) information about the neighborhood is revealed. In other words, when developers are uncertain about the success of their projects, they are willing to trade profit in the earlier stage for more certainty.
The third method is to presell a project. The presale method is to sell (or to lease) a unit before the completion of the project. (1) The presale approach is very popular in many of the cities in Asia (especially in China, Hong Kong, Singapore and Taiwan), and is also used in developments in North America and Europe. Compared with the other two methods, the presale method not only helps developers deal with the uncertainty of future demand (and potential bankruptcy costs), but can also substantially reduce (or eliminate) developers' inventory costs. Since a developer can have all units sold or leased before the project is completed, this method is particularly useful for large development projects (such as a 50-floor, 500-unit condominium project).
While the presale method has been very popular in Asia, little attention has been paid to the risk-and-return characteristics of this strategy for both developers and buyers of the presale contract. (2) Previous research on presales tends to treat a presale as a forward or futures contract (see, e.g., Shih 1992, Chang and Ward 1993, Chang 1994). In other words, once a presale contract is signed, it is implicitly assumed that a buyer will purchase the property when it is completed. However, the buyer may default on the contract if the property value has dropped significantly by the time the property is completed. In fact, some presale contracts explicitly allow buyers to terminate the contract by paying a prespecified forfeiture charge. While developers may be able to go to court to ask the buyers to cover the deficiency when they default, in reality, the high cost of obtaining such a judgment (since buyers can always claim that the default is due to the poor quality of the building) and the low likelihood of collecting the deficiency from the buyer even if a judgment is obtained make it unprofitable for the developers to take the buyers to court when they default. (3)
Recognizing that buyers have an option to default on a presale contract, this paper examines a developer's presale strategy using a real-options framework. (4) We first show how developers maximize their expected payoffs through a presale of residential units rather than selling them upon completion. We then extend the study to situations in which investors are wary about the reputation of the developers. When the reputation of developers is considered, our model is able to explain the existence of entry barriers in property markets where the presale method is popular (and why the markets are oligopolistic).
The organization of the paper is as follows. The next section briefly describes the use and mechanism of a presale system using a typical market (Hong Kong) as an example. The next section shows the optimal strategies a developer can use to launch a presale. Models for contract design and solving for the optimal level of final payments are shown in the fourth section. The last section concludes the paper.
Market Fundamentals
The Presale Mechanism
A presale is normally allowed only at certain periods after construction begins. In most regions, the normal practice is that the developer must complete a certain percentage of the project before the government will release a presale consent. That is, when a developer presells the unit, potential buyers can observe the percentage of the building that was completed at the time of sale (we call this asset in place).
A presale contract gives the buyer the right to buy a property at a preagreed payment schedule (which normally is in accordance with the progress of the construction). At the time the building is completed, the buyer makes a final payment and takes the title of the property. In the case of the Hong Kong market and some other Asian markets, the buyer has the right to terminate the presale contract at any point during the payment period by paying a forfeiture charge.
There are two major benefits for developers to conduct a presale. First, since properties are sold before completion, marketing costs and inventory costs are reduced. Second, the uncertainty about the future demand can also be reduced because projects can be presold (or preleased) at a time close to the date of making the investment decision. The reduction of holding costs alone can provide developers with enough incentive to use the presale system.
Second, without a presale system, there is an expected bankruptcy cost if a developer takes on a large project relative to the value of the developer's capital base. The concern about bankruptcy costs is a practical one for developers in many Asian cities where typical residential developments are comprised of hundreds to thousands of units and the price movements in property markets are quite volatile. Figures 1, 2 and 3 illustrate the property price movements in selected Asian cities. Figure 1 reports the residential price movement in Shanghai, China, during the 1995-2003 period. As can be seen from the figure, the property price in the city moved downward since the start of the index period (March 1995). The property price started to increase at the end of 1999. However, it took an additional 3 years (until the end of 2002) before the price level reached the 1995 level. If a developer did not presell the units in 1995, it is possible that she/he would face bankruptcy risk when the property is completed later on.
The movement of Hong Kong property price indexes seems to be more volatile than that in Shanghai. Figure 2 shows that the Hong Kong residential property price index peaked at 1,050 on September, 1997. The index dropped to around 390 in March 2003. (The office property price index follows a similar pattern.) Without a presale system, most developers in Hong Kong who started projects in 1997 might have faced serious trouble when their projects were completed. We have a long time series of residential prices for Taipei (1974-2003) and, as can be seen from Figure 3, the price level at the end of the index period (March 2003) was still lower than the price level in 1989. This pattern indicates that the volatile price movement presents a real threat to developers if they do not presell their properties. (5)
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The presale system also benefits buyers of the properties. Chang and Ward (1993) point out that during periods with a rapid increase in...
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