Question

CITIC Tower II: The Real Option

It was three o’ clock on a hot afternoon in Hong Kong in mid-2000. Larry Yung, Chairman

of Citic Pacific Limited (“CPL”), was having a board meeting with his property development

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team. From his window on the 33 floor of Citic Tower, he could see the impressive Victoria

Harbour and an undeveloped prime waterfront site. This piece of reclaimed land had been purchased by a company six months earlier at a public auction. Now, the owner wanted to dispose of it, and hence it was made available to CPL on a first-choice basis through an intermediary. Larry thought CPL could acquire the site and develop it into another Grade A office building in Central — he planned to call it “Citic Tower II”. The asking price of the land was HK$1 billion, and the estimated scale of the building and development costs were comparable to those of Citic Tower. Larry personally wanted to give this deal the go-ahead, but he was hesitant to commit his company to this two-to-three year project without seeking advice from his management team.

At the board meeting, Larry leaned back in his chair and riffled through the feasibility report he had been given. To his disappointment, investing in Citic Tower II did not seem to bring about clear positive returns. Under the rigid assumptions set by the property development team and the Net Present Value Rule, the project reflected a present value of around HK$1.54 billion and a cost of around HK$1.6 billion. Larry intuitively felt that the decision was too deterministic, as it did not allow for any flexibility, managerial discretion or strategic actions. Should he allow the board to reject or go ahead with this project based on discounted cashflow (DCF) analysis alone? If the decision to develop was delayed or otherwise changed, would the full potential of this development opportunity be substantially better than the analysis suggested?

Background

Citic Pacific Limited was incorporated in Hong Kong and listed on the Hong Kong Stock Exchange in 1991. In 2000, infrastructure and related assets formed the cornerstone of CPL’s activities, ranging from civil facilities such as complex bridge, road and tunnel facilities to power generation, environmental projects, aviation and telecommunications. CPL owned extensive trading and distribution interests, particularly in the motor industry, through its wholly owned subsidiary, Dah Chong Hong Limited. It also had stakes in firms such as Cathay Pacific, Dragonair and a string of trading and property companies.

Given the cyclical nature of the market, CPL’s property revenues were significantly less predictable than the revenues from the company’s infrastructure assets, where high proportions of its revenues were contractually defined and recurrent. Property investment projects were generally based on 12 per cent required return on investment based on CLP’s weighted average cost of capital (WACC), with no attempt to differentiate for individual project risk in WACC. Over time, CPL’s property development team had gained extensive expertise and knowledge in the property business. The development of Citic Tower, which began in August 1995, and completed in less than two years, represented an impressive achievement in development management. As at 1999, despite the property market being affected by the post-Asian financial crisis, weak demand and falling prices, Citic Tower still maintained a relatively high occupancy rate.

Larry knew that the commercial real estate market was extremely cyclical, and that very few companies active in the market had managed to time rental cycles and investment strategy successfully (Exhibit 1 shows the Grade A office rental and capital value time series from 1986 to 2001, and Exhibit 2 provides information on recent risk-free rates in Hong Kong). Although Citic Tower I had managed to survive the economic downturn unscathed, there was no guarantee that things would be any easier for Citic Tower II. Given the volatile nature of the market, the mark of a successful project was when the developer knew when to pull in the reins and when to let them out.

With this in mind, Larry thought the outlook for the project could change if it could be deferred or otherwise re-scaled. With a possible negative net present value, launching the project at this point was unambiguously sub-optimal. However, things could change over time. At some point, the property market could be on the upturn again. If Citic Tower II came onto the market at the right time, it might be far more promising than it appeared in mid-2000.

The Real Option

Larry’s doubts about the rigid application of the DCF analysis led to more discussions on the alternatives available surrounding the development of Citic Tower II. At the end of the meeting, Larry was glad that the board did not reject the proposal. In fact, as the debate flared up, members of the property development team floated some useful ideas.

Early investment in the Citic Tower II project meant sacrificing the option to defer the decision to go ahead immediately, which was valuable because of high uncertainties and the long investment horizon associated with the property development industry. One member therefore suggested that the company acquire the rights to the land, and thus the development, by offering to purchase an exclusive option from the seller. The option to purchase the land would allow CPL to defer the decision to develop for one year. Such an option was also not without risks. If the project was truly a winner, waiting would mean loss or deferral of its early cashflows. However, since the project did not appear to be clearly attractive at this point, waiting could prevent a big mistake. On this point all members of the board were in complete agreement. The question, however, was how to lure the seller to accept such an offer.

Negotiations

Three years earlier, land owners would not have even considered negotiating an option to purchase development sites. At that time, commercial development sites were keenly sought

after despite the high land prices. Demand for office space in Central was particularly strong, as its prime location attracted the banking and financial sectors, major accountancy and legal firms as well as regional headquarters of multinational corporations. Multiple offers and aggressive bids were often found at land auctions. However, as the market cooled after the Asian financial crisis, that scenario was no longer the case. Property developers seemed to be more cautious than before, and most preferred to stay on the sidelines.

Given the present economic climate, CPL was hoping that the seller would grant CPL an option to defer purchase of the land, exercisable at the end of one year, thereby allowing CPL to defer the whole project for one year. Two weeks earlier, the seller had reached a new agreement with its banker to restructure its HK$3 billion debts, thereby alleviating its short- term cashflow problems. Under the agreement, the repayment would be extended from two years to three years, including a grace period of 12 months. The refinancing not only provided a big boost to the seller’s share price, but it would also better position both the company and CPL to negotiate more flexible terms for the land sale.

CPL’s early talks with the seller were encouraging. The seller had shown an interest in granting an exclusive option for 12 months. However, as the price of the option, it had requested an equity stake of 5% in the completed project.

The Decision

Larry sat at his desk overlooking the newly reclaimed land on the waterfront of Victoria Harbour. He was a little perplexed about the decision in front of him. The exclusivity option offered additional choices, but at the same time it was difficult to assess. Should CPL accept the terms proposed by the seller? Larry sighed, picked up his jacket and headed for the last board meeting in July. He wondered whether his property development team would still reject the project after two weeks’ study of this decision.

1. What is offered in the exclusivity option?

2. Should CPL accept the terms proposed by the seller? Why?

Answer 1

The exclusivity option offered:

• The rights to the company to acquire the land
• An option to defer the decision to go ahead immediately
• An option to to defer the decision to develop for one year.

The option thus provided the safest route to investment which was valuable because of high uncertainties and the long investment horizon associated with the property development industry.

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Should CPL accept the terms proposed by the seller? Why?

Yes, the option eventually has a cost and the buyer of the option has to pay that cost to the seller. Hence, CPL must pay to the seller. The good this here is, the seller is not asking for an immediate, cash payment for this option. In stead, it's asking for 5% stake in the completed project. The seller should accept the terms proposed by seller because:

• There is no immediate cash payment for acquiring the rights.
• Hence, there will be no monetary loss on immediate basis.
• The stake sought for in return is just 5% equity stake that also in this project.
• If the project does well, parting away with just 5% stake in an attempt to mitigate so many uncertainties in the project is not a bad deal.
• If project does well, the seller makes money along with you. If the project doesn't do well, the seller suffers along with you
• Overall CPL is definitely not worse off under this proposal.