A COMPARATIVE STUDY ON THE RISK-RETURN BEHAVIOR OF REAL ESTATE MEZZANINE INVESTMENT IN SINGAPORE AND HONG KONG

Abstract

Mezzanine financing refers to the intermediate level that can exist in the capital structure between debt and equity. Accordingly, this form of financing is subordinate in priority of payment to senior debt, but senior in rank to common stock or equity. Since mezzanine debt has a lesser priority than senior debt in regards to the company’s loan repayment obligations, it is important for the investor to price the real estate mezzanine investment appropriately on a risk-adjusted return principle to provide adequate compensation for the risk taken. This report aims to examine the risk and return structure of real estate mezzanine investment in Asian region, in particular the two key capital cities of interest – Singapore and Hong Kong. Using a discrete-time binomial asset tree model for the ex-ante investigation of real estate mezzanine investment, we have simulated a series of cash flow for mezzanine investment under different “ups and downs” market scenarios. Such cash flows are used to derive the return for mezzanine investment, which will then be analyzed under different loan scenarios to come to the conclusion. Result shows that the mezzanine investment is subjected to default risk, which makes its total return less than its interest rate. Market risk and financial risk are the two main drivers for the default risk of real estate mezzanine investment. On analyzing the spread between mezzanine investment total return and its interest rate shows that such spread increases as the senior loan LTV ratio increases but remain constant throughout different mezzanine interest rates. Thus, it can be concluded that financial risk (depicted by the senior loan’s LTV ratio in the capital structure) is the important cause of default probability for real estate mezzanine investment, given constant market risk. Moreover, comparing between the Singapore and Hong Kong prime office markets shows that the Singapore market for real estate mezzanine investment seems to be riskier but provides better return given the same market and financial condition.