HKU Real Estate Finance

Pre-Sale Transactions
Kwok-Sang (Maurice) Tse

Faculty of Business and Economics

The University of Hong Kong
ktse@hku.hk

k s tse 1
◼ Reference
◼ “Do the Forward Sales of Real Estate Stabilize
Spot Prices?”, Journal of Real Estate Finance
and Economics, 2006
 Introduction
◼ Before the crash of the real estate market in 1998 in Hong
Kong, the pre-sale market had always been blamed for the sky
high property price level which was beyond reach by many who
wanted to become property owners.
◼ To the investors in the real estate market, pre-sale transaction
was a quick way to generate quick returns and profits.

◼ Example
◼ Consider a residential property on Hong Kong Island called, Illumination
Terrace, Tai Hang Rd 5-7, Jardine’s Lookout (Appendix).
 HP Day
Floor Unit Price G. Area T. Date OP Date # days return Return
1 E 2.755 758 5-May-93 93/07

Example Contd: 1
1
E
F
3.25
2.492
758
696
22-Jun-93
29-May-92
93/07
93/07
48 16.52% 0.34%

1 F 2.432 696 6-Jun-92 93/07 8 -2.44% -0.30%

1 F 2.62 696 19-May-93 93/07 347 7.45% 0.02%
◼ Illumination 1 F 2.6 696 25-May-93 93/07 6 -0.77% -0.13%
1 F 2.92 696 24-Jun-93 93/07 30 11.61% 0.39%
Terrace (光明台), 1 G 2.473 696 9-May-92 93/07
1 G 3.13 696 19-Jun-93 93/07 406 23.56% 0.06%
Tai Hang Road, 2
2
C
C
3.839
4.49
979
979
18-Jun-92
26-May-93
93/07
93/07 342 15.66% 0.05%
5-7,Jardines’s 2
2
D
D
3.267
3.521
903
903
7-Jul-92
10-Jul-92
93/07
93/07 3 7.49% 2.50%
Lookout (渣甸山) 2
2
D
D
3.73
3.7
903
903
18-May-93
5-Dec-93
93/07
93/07
312
201
5.77%
-0.81%
0.02%
0.00%
2 F 2.455 696 1-Jun-92 93/07
2 F 2.591 696 2-Jul-92 93/07 31 5.39% 0.17%
◼ Pre-Sale 2
2
G
G
2.501
2.53
696
696
8-May-92
20-May-92
93/07
93/07 12 1.15% 0.10%
Transactions in 2
2
G
G
3.152
2.68
696
696
19-Apr-93
30-Apr-93
93/07
93/07
334
11
21.98%
-16.22%
0.07%
-1.47%
Upper Units 2
2
H
H
2.599
2.77
769
769
5-May-92
28-May-92
93/07
93/07 23 6.37% 0.28%

between May 92 2
3
H
C
2.73
3.871
769
979
4-Aug-93
4-May-92
93/07
93/07
433 -1.45% 0.00%

3 C 4.1 979 5-May-93 93/07 366 5.75% 0.02%

to July 93 3 D 3.301 903 8-Jul-92 93/07
3 D 3.63 903 5-Mar-93 93/07 240 9.50% 0.04%
◼ OP = 3
3
F
F
2.291
2.683
696
696
10-Mar-92
7-May-92
93/07
93/07 0 5.48%

Occupation 3
3
F
F
2.54
2.6
696
696
7-May-92
4-Mar-93
93/07
93/07
58
301
10.32%
-3.14%
0.18%
-0.01%

Permit 3
3
G
G
2.553
2.95
696
696
11-May-92
16-Jun-93
93/07
93/07 401 14.45% 0.04%
3 H 2.662 769 2-Jun-92 93/07
3 H 3.26 769 6-Aug-93 93/07 430 20.26% 0.05%
 HP Day
Floor Unit Price G. Area T. Date OP Date # days return Return
40 D 3.704 910 28-Jan-92 93/07

Example Contd:
40 D 4.2 910 30-Apr-93 93/07 458 12.57% 0.03%
40 E 2.918 758 5-Mar-92 93/07
40 E 3.158 769 28-Apr-92 93/07 54 7.90% 0.15%
40 E 3.53 769 6-Feb-93 93/07 284 11.14% 0.04%
40 E 3.43 769 13-Apr-93 93/07 66 -2.87% -0.04%
40 E 3.968 769 19-Jun-93 93/07 67 14.57% 0.22%
◼ Illumination 40
40
H
H
2.995
3.28
769
769
4-Mar-92
25-Mar-93
93/07
93/07 386 9.09% 0.02%

Terrace (光明台), 41
41
F
F
2.656
3.18
696
696
28-Feb-92
5-Nov-93
93/07
93/07 616 18.01% 0.03%

Tai Hang Road, 41

41
G
G
3.28
4.1
696
769
20-May-93
29-Jun-93
93/07
93/07 40 22.31% 0.56%
42 C 4.72 989 3-Nov-93 93/07 127 14.08% 0.11%
5-7,Jardines’s 42 C 5.545 989 6-Nov-93 93/07 3 16.11% 5.37%
42 E 3.173 769 29-Apr-92 93/07
Lookout (渣甸山) 42
42
E
F
3.502
2.671
769
696
21-May-93
13-Feb-92
93/07
93/07
387 9.87% 0.03%

42 F 3.05 696 15-Mar-93 93/07 396 13.27% 0.03%

42 G 2.74 696 7-Mar-92 93/07
◼ Pre-Sale 42 G 2.879 696 17-Mar-92 93/07 10 4.95% 0.49%
42 G 3.268 696 3-Jan-93 93/07 292 12.67% 0.04%
Transactions in 42
42
G
G
3.16
3.15
696
696
4-Feb-93
14-May-93
93/07
93/07
32
99
-3.36%
-0.32%
-0.11%
0.00%
Upper Units 42
42
H
H
2.769
3.83
769
769
2-Mar-92
31-May-93
93/07
93/07 455 32.44% 0.07%

between May 92 to 43
43
A
A
4.98
4.5
910
910
5-Jul-93
3-Dec-93
93/07
93/07
35
151
26.26%
-10.14%
0.75%
-0.07%
43 C 2.958 696 4-May-92 93/07
July 93 43 C 4.48 989 4-Aug-93 93/07 457 41.51% 0.09%
43 E 2.933 769 6-Mar-92 93/07
43 E 3.173 769 30-Apr-92 93/07 55 7.87% 0.14%
43 E 3.58 769 6-Jan-93 93/07 251 12.07% 0.05%
43 E 3.28 769 15-Mar-93 93/07 68 -8.75% -0.13%
43 G 3.215 696 26-Apr-93 93/07 42 -2.00% -0.05%
43 G 3.215 696 4-Aug-93 93/07 100 0.00% 0.00%
44-45 A 5.163 1230 17-Mar-92 93/07
44-45 A 6.3 1230 24-May-93 93/07 433 19.90% 0.05%
44-45 A 6.55 1230 6-Oct-93 93/07 135 3.89% 0.03%
 Important Figures
◼ The average holding period = 92 days
◼ The average holding-period returns = 10.21%
◼ The average daily return = 0.187%
◼ The annualized average return = 28.48%
◼ The return on Hang Seng Index between May 92 and July 93 = 16%
◼ The units with the highest average daily return

HP Daily
Floor Unit Price G. Area T. Date OP Date # days return Return
22 B 5.35 989 93/07 1 6.77% 6.77%
42 C 5.545 989 93/07 3 16.11% 5.37%
2 D 3.521 903 93/07 3 7.49% 2.50%
7 D 3.334 910 93/07 4 7.08% 1.77%
8 F 3.73 696 93/07 26 36.48% 1.40%
23 A 3.83 910 93/07 37 33.13% 0.90%
43 A 4.98 910 93/07 35 26.26% 0.75%
 Introduction Contd
◼ In 1995, the Hong Kong Government said, “Pre-sale market is
the hotbed of speculative activities in the real estate market.”
◼ Since then the Government had been using “pre-sale market” as
a tool to contain speculative transactions and hence the upward
pressure of the property market price level.
◼ For example, in 1995, the Government essentially prohibited
pre-sale market transactions.
◼ Effects: A plunge in the supply of residential real estate.

◼ After the Asian financial crisis broke out, the property price in
Hong Kong fell by as much as 70 percent.
◼ And the HKSAR Government began to relax the restrictions on
pre-sale transactions with the hope to revive the level of
transactions in the property market.
 ◼ Jan2011:
Dec 2002: $3,000 psf
>$8,800
Property Price ◼
◼ July 2003: $2,200-2,400 psf
◼Dec 2014: > $18,000
in Hong Kong ◼ April 2004: $3,500-$3,800 psf
◼Dec 2016: > $19,000
◼ Dec 2007: $5,500 psf
◼ TKS = Tai Koo Shing ( 太 古 城), 28-30 years old residential estate on east side
of Hong Kong Island, popular choice of residence among expatriates.
Residential Property Price
per sq. ft of gross area TKS Asian

Oct 97: Financial

Jun 94: Crisis
9000 $5200 psf $8400 psf
8000 Dec 95:
7000 $4200 psf
6000 Jan 98:
Price
5000
Pre-Sale $6800 psf
4000
prohibited Handover
3000 by HKG Outlook
2000
1000
0
Jan-92

Jan-93

Jan-94

Jan-95

Jan-96

Jan-97
May-

May-

May-

May-

May-

May-
Sep-

Sep-

Sep-

Sep-

Sep-

Sep-
Month/Year
k s tse 8
 Introduction
◼ Function of Pre-sale Market to Real Estate Developer
◼ Questions:
◼ What’s the use of the pre-sale market to the
developer??
◼ What’s the effect of pre-sale transaction on the real
estate supply??
◼ From what happens in the pre-sale market, what can
we say about developers’ view on the future real
estate prices??
 Supply Decision of Real Estate Developer
◼ Supply quantity ??
◼ Pre-sale quantity ??
Supply quantity (q)?
Sell the rest of the units (q-h)
How many units (h) to pre-sell?
Price is unknown at t = 0
Pre-sale Price known (pf)

Start of
Construction End of
Construction
Today t = 0
k s tse 10
 Analysis
◼ Sell h units in the presale market at fixed price pf today
◼ Sell the rest (q - h) at the unknown spot market price at
the end of construction.
◼ Current & Projected Market Conditions affect the
presale market price pf .
◼ Pre-sale revenue:
◼ Can be invested in other projects

◼ Can pay off existing debts (Cost savings)

◼ Future spot price (p) upon completion of construction is

uncertain and is represented by ~p
◼ Developer is risk-averse.
Analysis: Developer’s Profit
◼ Profit Function
◼ q = number of units to build
◼ h = number of units to pre-sell
◼ C (q) = variable cost with:
◼ C ’(q) > 0 and C ”(q) > 0.

◼ Assume C(q) = c/2 x q

2 for simplicity.

◼ B = the fixed costs of development

 Analysis: Profit Contd
◼ Developer’s profit ??
~ ~ c 2
 = p f h +  ( p f h) r + p ( q − h) − q − B
2
◼ 1st term = presale revenue
◼ 2nd term = $ return on the use ( %) of presale revenue
◼ 3rd term = sales revenue by selling the remaining units
at the end of the construction period
◼ 4th term = Variable Cost
◼ 5th term = Fixed Cost
◼ Price Risk (profit risk)???
 Analysis: Price Risk (profit risk)
~ ~ c 2
 = p f h +  ( p f h) r + p ( q − h) − q − B
2
◼ Uncertain future price : ~ p
➔ Uncertain profit function
➔ Must forecast the future spot price.
◼ Forecasting uncertain future spot price (unbiased):
p = p +e
◼ p : expected (mean) future spot price
◼ e : forecast error with E(e) = 0 and Var(e) = sp2.
◼ E(~p) = p and Var( ~p) = sp2.
◼ Variance term (sp2) = price risk faced by the developer.
 Analysis: Profit Risk Contd
~ ~ c 2
 = p f h +  ( p f h) r + p ( q − h) − q − B
2
◼ Profit with Price Risk
◼ Expected profit E(~) to the developer ??
c
E (~) = p f h +  ( p f h)r + p(q − h) − q 2 − B
2
◼ Variance of profits Var(~) to the developer??
Var(~) = (q − h) 2 s p2
◼ Question:
◼ If the government prohibits pre-sale transactions in the real

estate market, how would the profit risk affect the supply
decision of the developers??
 Analysis: Effect of Risk-Aversion
◼ Developer is risk averse.
◼ He likes POSITIVE surprise; and he dislikes NEGATIVE
surpise.
◼ Since they are risk averse, they are conservative when
making development decisions based on the projected
profit.
◼ Developer will not choose q and h just to maximize
expected profit.
◼ Developer will maximize the certainty-equivalent profit.
◼ What is certainty-equivalent?? Concept??
 Concept of Certainty Equivalent
◼ Certainty Equivalent is the amount of money the developer is
willing to take in order to avoid taking the profit risk.

◼ Example: Fire Insurance

◼ A property is worth $5m.
◼ In case of a fire, value destroyed is $1.8m on average.
◼ Fire insurance = $0.5m
$3.2m $5m- 0.5m =4.5m

Fire Fire ◼ $4.5m can be regarded as

the certainty equivalent
No Insurance Insurance
of the property owner.
No fire No fire

$5m $4.5m
 Concept of Certainty Equivalent
◼ How much insurance the property owner wants to buy depends
on his/her degree of risk aversion.
◼ The more risk aversion, more insurance will be purchased, hence
the smaller the certainty equivalent.
◼ The amount of insurance purchased also depends on the
probability of fire risk (or the variance of his/her net wealth after
fire risk)
$3.2m $5m- 0.5m =4.5m

Fire Fire

No Insurance Insurance

No fire
No fire
$4.5m
$5m
 Certainty Equivalent of Profit
◼ The amount of profit the developer is willing to give up to
avoid risk can be described by the following picture


Variance
Var(~)
2

Mean Profit

◼ /2 = trade-off at equilibrium between expected profit and

variance of profit.
 Certainty Equivalent of Profit Contd
◼ Developer will choose the scale of development (q)
and the presale quantity (h) to maximize the
certainty-equivalent profit (CE) which is given by:

E ( ) − Var(~)
~
2
◼ Another way to describe this certainty equivalent
of profit is that the developer, because of risk
aversion, will only make decision based on a
more conservative forecast of future profit.
 Certainty Equivalent of Profit Contd
~ c 2
◼ Recall E ( ) = p f h +  ( p f h)r + p(q − h) − q − B
2
Var(~) = (q − h) 2 s p2

 CE = E ( ) − Var(~)
~
2
◼ Hence, the certainty equivalent of profit ??
 
 CE
 c 2

=  p f h +  ( p f h)r + p(q − h) − q − B  − (q − h) 2 s p2 
 2  2
◼ Objective of the developer: Maximize the certainty-
equivalent profit by choosing the optimal q and h.
Optimal Decision by Developer
 
 c 2

 CE =  p f h +  ( p f h)r + p(q − h) − q − B  − (q − h) 2 s p2 
 2  2
◼ The corresponding first order conditions are:

 CE
= p − cq −  (q − h)s p2 = 0
q
 CE
= p f +  r p f − p +  (q − h)s p2 = 0
h
◼ The solution for optimal supply of units of property (q*) is
found by adding the two equations together:
p f (1+ a ´ r)
p f + a r p f - cq = 0 Þ q = *

c
 Implications of Pre-Sale Market
◼ Supply of space depends only on
◼ pre-sale price
p f (1 +   r )
◼ variable cost
q *
=
c
◼ use of pre-sale revenue

◼ opportunity cost of pre-sale revenue

◼ Price risk can be eliminated by hedging (pre-selling some units).

◼ The development decision is made as if the development were
in a risk-free environment.
◼ Developer should produce until the marginal variable cost
equals the price per unit of space in the pre-sale market and
the corresponding reinvestment return.
Question

◼ If the government prohibits pre-sale transaction in

the real estate market, how would the profit risk
affect the supply decision of the developer??
 What if Pre-Sale Market Does Not Exist ?
◼ If pre-sale market does not exist, h = 0.
◼ Optimal supply of real estate from the first order condition
with respect to the supply quantity q is:

 CE p
= p − cq −  (q − h)s p2 = 0 q =
'

q c + s 2
p

◼ Optimal supply decision The higher the price risk (sp2 ), the
depends on: lower the supply quantity (q’ ).
◼ Expected future spot price

◼ Variable Cost The more risk averse () the

◼ Price risk
developer is, the lower the supply
quantity.
◼ Risk aversion
 Implications of Prohibiting Pre-Sale
Transactions
◼ Comparing q’ (without pre-sale) with q* (with pre-sale) allows us
to see that at each price level (p and pf), the supply of real estate
is higher with pre-sale transactions than without

Price
p q’
q' = q*
c + s 2
p

p f (1 +   r )
q =
*

c
0 Supply Quantity
Statement about Pre-Sale Transaction

◼ The existence of pre-sale market that allows the

developer to transfer price risk to the buyers induces
the developer to produce more because the
developer is not paying risk costs along with other
production costs.
 What About the Pre-Sale Quantity?
◼ From the first order condition dCE/dh = 0 above, we can
solve for the optimal pre-sale quantity h*:
p − p f (1 +   r )
h =q −
* *

s p2
◼ Implications:
◼ If p < pf (1 +  r), total output of space q* will be pre-sold.
◼ A risk averse developer will exchange an uncertain price
for a certain one if the latter equals the expected value
of the uncertain one.
◼ However, the expected and the actual future spot price
may not be equal.
 p − p f (1 + r )
Implications Contd h =q −
* *

s p2
◼ Risk averse developers will exchange a certain price pf for the
uncertain spot price only if the expected spot price includes a risk
premium. That is,
p > pf (1 + a r)
◼ Consider the case when p > pf (1 + a r)
◼ Now q* must exceed h* and the firm will hedge some of its space
output.
◼ The developer sells part of the output at the forward price pf and
sells the rest upon completion for the uncertain spot price.
◼ The more risk-averse the developer, the greater the level of
hedging for the same positive price difference between p and pf .
 p − p f (1 +   r )
Implications Contd h =q −
* *

s p2
◼ Questions: What can we say about the effect of the
following factors on the pre-sale quantity??

◼ The developer’s need for fund ()

◼ The opportunity cost faced by the developer (r)
◼ Expected future spot price (p)
◼ Risk aversion factor ()
◼ Property price risk (s)
End