AN EXAMINATION OF THE RISK-RETURN BEHAVIOR FOR REAL ESTATE MEZZANINE INVESTMENT - SINGAPORE, BANGKOK AND KUALA LUMPUR MARKET EXPERIENCE

Abstract

Mezzanine investment is a new financial instrument for the real estate market in the Asian region and it should provide superior returns than those for usual typical commercial bank loans, owing to relatively higher risks involved. Therefore, it is important for the investor to price the real estate mezzanine investment appropriately on a risk-adjusted return principle to ensure adequate compensation for the risk taken. This dissertation’s study is motivated to examine the risk-return behavior of mezzanine investment in the BK, KL and SG markets. The study adopts a discrete-time binomial asset tree model for the ex-ante examination of real estate mezzanine investment. The empirical analysis involves a rigorous discrete-time forecasting of the market rent and capital value of the BK, KL and SG prime office markets, given the assumptions typical of each market. Subsequently, the total return for mezzanine investment is analyzed using a probability-weighted average cash flow approach under different loan to value ratios and mezzanine interest rates. This study conducts the required empirical analysis and it affirms the study’s two research hypothesis. In particular and in adopting the common assumptions specific to the SG, BK and KL prime office markets, a series of default probabilities are estimated on the basis of the risk neutral principle and for each respective market’s mezzanine investment interest rate. Market risk and financial risk are the two main drivers for the default risk of real estate mezzanine investment. The impact of financial risk on the mezzanine investment total return is examined. It is found that a generally stable spread exists between the mezzanine investment’s original interest rate and its real total return especially for the SG and BK markets. This study also examines the financial risk by changing LTV ratio. The results show that such a spread tends to be stable for each different LTV ratio. This spread increases as the senior-loan LTV ratio increases and it follows a “staircase shape”. The KL market behaves differently with a changing LTV ratio of the senior loan in comparison with the SG and BK markets. The KL market showcases a lucrative market for mezzanine investors. The results affirm the real estate market risk and the financial risk are the main risk factors that affect the return for the mezzanine investment.