HKU Real Estate Finance

Speculative Transactions
in Real Estate

K. S. Maurice Tse
The University of Hong Kong
ktse@hku.hk

kstse 1
Contents
 Real Estate Price Risk and Speculative Real
Estate Transactions
 Financial Implications of Real Estate
Transactions

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 Introduction
 Example.
 A buyer would like to buy the

following property from the

seller.
 The agreed price is $10 million.

 The buyer will make a down

payment equal to 20% of the

agreed price.
 Time for closing the transaction is

9 months.

• What could happen between the buyer and the

seller before the transaction is completed?
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 Example: Buyer’s Intention #1
 The transaction can be depicted by the following event line.
The Buyer looks for
another buyer to buy
at a price better than
$10m before closing

0 Time t 9 months

Buyer and seller sign a

preliminary sale & purchase
agreement
Contracted price (Pc) = $10m
Down = 20% of Pc

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 Example: Buyer’s Intention #2
 The transaction can be depicted by the following event line.

Buyer applies Bank appraises

for bank the market value
financing of the house
(Mortgage)

0 Time t 9 months

Buyer and seller sign a Mortgage Policy:

preliminary sale & purchase 70%*MIN{Contracted
agreement Price, Appraised Value}
Contracted price (Pc) = $10m
Down = 20% of Pc

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 Default by Buyer Mortgage Policy:
70%*MIN{Contracted
Price, Appraised Value}
 If appraised market value = $8m
 Mortgage amount = 0.7 * ($8m) = $5.6 m

 Additional Fund needed for closing = 10 – 2 – 5.6 = 2.4m

 If appraised market value = $6m

 Mortgage amount = 0.7 * ($6m) = $4.2 m

 Additional Fund needed for closing = 10 – 2 – 4.2 = 3.8m

 If the appraised market value is substantially lower than the

contracted price, the amount of bank financing may not be enough
for the buyer to close the transaction.

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 Default by Buyer
 Buyer’s default is very likely when the property market is
going deep south.
 In this case, the buyer may have to default due to

insufficient fund.
 The buyer may also walk away in order to “stop loss”.

 In case of default, the buyer will give up the amount

of down payment to the seller.

 Of course, the seller may sue the buyer for the price

loss. (Rare!)

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 Default by Seller
 Seller may also choose not to complete the transaction with the
buyer, especially during period of upswings in property price.
 Seller may receive an offer from another buyer that is significantly
higher than $10m, say $13m.
 Seller may be tempted to walk away from the first buyer, turn
around and sell the property to the 2nd buyer with higher offer.
 In Hong Kong, the seller returns the down payment to the

buyer, and
 The seller pays the buyer an additional amount equal to the

down payment (compensation/penalty).

 Of course, the first buyer may sue the seller (Rare).

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Contents
 Real Estate Price Risk and Speculative Real
Estate Transactions
 Financial Implications of Real Estate
Transactions

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 Financial Implications
 What is the price range within which the
transaction has a good chance to be
completed?
 What is the price range beyond which the
transaction is likely not going through???

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 Financial Implication: An Example
 Suppose a property investor enters into a sale and
purchase agreement with the property seller with the
following terms:
 Property Price agreed = $10 million

 % Down payment = 20%

 Amount due at closing = $8 million

 Negotiated closing period = 9 months

 Seller Information
 Original Purchase Price = $5 million (some years ago)
 In case of seller’s default, seller will return two times
the down payment to the buyer.
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 Example: No Default (see Excel Template)
 Property Price agreed = $10 million
 % Down payment = 20%; Amount due at closing = $8 million
 Original Purchase Price to Seller = $5 million
No Default
20
Payoff to Buyer Payoff to Seller
18
16
Potential Gain
14
12 to Buyer
10
8
6
4
$5m profit
2
0 to seller
-2 0 2 4 6 8 10 12 14 16 18 20 22 24
-4
-6
Potential Loss
-8
-10
to Buyer
-12
Property Price
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 Example: Buyer Default
 Property Price agreed = $10 million
 % Down payment = 20%; Amount due at closing = $8 million
 Original Purchase Price to Seller = $5 million
With Buyer Default
20
Payoff to Buyer Payoff to Seller
18
16 Property Payoff to Buyer Payoff to Buyer Payoff to Seller
14 Price (No Default) (Default)
12 6 6 – 10 = (4) (2) 6+2–5=3
10
9 9 – 10 = (1) (2) 10 – 5 = 5
8
6
4
2
0
-2 0 2 4 6 8 10 12 14 16 18 20 22 24
-4
-6
Property Price

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 Example: Seller Default
 Property Price agreed = $10 million
 % Down payment = 20%; Amount due at closing = $8 million
 Original Purchase Price to Seller = $5 million
20 With Default by Buyer and Seller
Payoff to Buyer Payoff to Seller
18
16 Property Payoff to Seller Payoff to Seller Payoff to Buyer
Price (No Default) (Default)
14
12 11 10 – 5 = 5 11 –5– 2 = 4 11 – 10 = 1
10 16 10 – 5 = 5 16– 5– 2 = 9 2
8
6
4
2
0
-2 0 2 4 6 8 10 12 14 16 18 20 22 24
-4
-6
Property Price
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 Questions for Discussion
 In a real estate transaction, the gain or loss to one
party, either the buyer or the seller, is also the loss or
gain to the other party.
 It is a zero sum game.
 Since either party may default in the transaction,
 what does the overall payoff to both parties look like,
 what is the price range within which the transaction has a
good chance to complete,
 what is the price range beyond which the transaction is not
going to go through???

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 Example: Buyer and Seller Default
 Property Price agreed = $10 million
 % Down payment = 20%; Amount due at closing = $8 million
 Original Purchase Price to Seller = $5 million
20 With Default by Buyer and Seller
Payoff to Buyer Payoff to Seller
18
16 Normal
14 Transaction
12 Buyer may
10 default Seller may default
8
6
4
2
0
-2 0 2 4 6 8 10 12 14 16 18 20 22 24
-4
-6
Property Price
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 Example: Buyer and Seller Default
 Property Price agreed = $10 million
 % Down payment = 20%; Amount due at closing = $8 million
 Original Purchase Price to Seller = $5 million
20 With Default by Buyer and Seller
Payoff to Buyer Payoff to Seller
18
16
14
12
10
Short Put Long Call
8 Payoff to Seller if
(X = 8) (X = 12)
6 No Default
4
2
0
-2 0 2 4 6 8 10 12 14 16 18 20 22 24
-4
-6
Property Price
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 Example: Buyer and Seller Default
 Property Price agreed = $10 million
 % Down payment = 20%; Amount due at closing = $8 million
 Original Purchase Price to Seller = $5 million
20 With Default by Buyer and Seller
Payoff to Buyer Payoff to Seller
18
16
14
12
10
8
Payoff to Buyer if
6
No Default
4
2
0
-2 0 2 4 6 8 10 12 14 16 18 20 22 24
-4 Long Call Short Call
-6 (X = 8) (X = 12)
Property Price
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 Example: Buyer and Seller Default
 Property Price agreed = $10 million
 % Down payment = 20%; Amount due at closing = $8 million
 Original Purchase Price to Seller = $5 million
20 With Default by Buyer and Seller
Payoff to Buyer Payoff to Seller
18
16 The Payoff to Buyer is a
14 “Bullish Vertical Spread”.
12
10
Short Put Long Call
8
(X = 8) (X = 12)
6
4
2
0
-2 0 2 4 6 8 10 12 14 16 18 20 22 24
-4 Long Call Short Call
-6 (X = 8) (X = 12)
Property Price
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 Summary of Speculative Default
 Property Price agreed = $10 million
 % Down payment = 20%; Amount due at closing = $8 million
 Original Purchase Price to Seller = $5 million
 Suppose either the property buyer or the seller can opt to walk away
from the transaction.
 The payoff (profit and loss) to the buyer and seller are as follows:
Property P/L to Buyer P/L to Seller based on P/L to Seller based on P/L to
Price (Price = $10m) purchase cost of $5m today’s price $10m Property
6 (2)* 6+2–5=3 6 + 2 – 10 = (2) 6 – 10 = (4)
9 (1) 10 – 5 = 5 10 – 10 = 0 9 – 10 = (1)
11 11 – 10 = 1 10 – 5 = 5 10 – 10 = 0 11 – 10 = 1
16 2 16 – 5 – 2 = 9** 16 – 10 – 2 = 4** 16 – 10 = 6
Note: (*) Indicates default by Buyer; (**) indicates default by seller

Note that the sum of the P/L to Buyer and the P/L to Seller based on
today’s price of $10m is equal to the P/L to the Property itself.
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End of Lecture

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