Rental Guarantee – Understand before you invest

Recently, housing developers have come with interesting ways to market their properties.  One recent example in the papers is the rental guarantee offered by the developer CD Developers for investors in Grande Towers, Dhapasi for a limited number of units. Figure 1 shows the ad that appeared in the Kantipur daily of September 11, 2014.  The guarantee is for five years and ranges from USD250 per month for a one BHK apartment to USD1,500 for a 4 bedroom Duplex.  This is an ingenious method of trying to instill a false sense of rental security to potential investors. The real estate market in Nepal is a buyer beware market. 

Figure 1: Advertised in Kantipur daily of 2014/09/11 for Grande Towers

 

What are some of the questions you might want to ask before investing in one of the apartments at Grande Towers?

First you might want to find out the specifics of the guarantee and how it works.  What does the fine print say? When can you make claims and get recompensed? Can you immediately exchange the guarantee for a five year lease to the developer so you do not have to worry about looking for tenants?

Second will the developer live up to its guarantee?  Once you have handed your money, there is very little you can do but rely on the developer’s goodwill to fulfil its end of the guarantee. Of course, you have the legal route but that has its own issues and challenges in Nepal.

Third you might want to know value of the guarantee you are receiving?  Mathematically, you can calculate this as the present value of an annuity that pays the guaranteed monthly rent for five years discounted at your expected return rate. We will look at an example later.

Fourth and probably the most important part of your analysis will be to get an idea of the rental ability or salability of the apartment after the guarantee is over.  This will depend on the state of your apartment, the state of the apartment complex, the availability and demand of apartments in Kathmandu.  Unless your apartment is in an ideal location, people who rent will always prefer newer apartments for the same rental rate.  As I have written in my previous articles related to the real estate market in Nepal, the pool of clients who can afford these upper-end rental units is very limited.  The same is true of the salability of apartments. Unless the location is such that it will always be in demand, the price of most apartment units will decline over time.  Investors will also tend to prefer new apartments for the same price in similar locations.  My personal view is that rentability and salability of upper-end apartments in Kathmandu is very uncertain.

Let us now do an exercise to get an idea of the value of one these apartments from an investor’s perspective and also from a developer’s perspective.

The value of the apartment from an investor’s perspective is basically the sum of three components: (a) the value of rental income during the guarantee period, (b) the value of the rental income during the non-guarantee period and up to the time of the sale of the apartment, and (c) the sale value of the apartment at time of sale.  For now let us ignore recurring expenses such as taxes, and maintenance which can sometimes be pretty large.   

For this exercise let us assume that you can immediately exercise the guarantee that is give the developer the apartment on lease in exchange for the monthly rental guarantee. When you do this, you will have given the right of the use of the apartment for five years.  Let us also assume that your target rate of return is 10% and that exchange rate will be fixed at 96 Nepalese rupee per US dollar.  With these assumptions we can calculate the value of the guarantee. 

Table 1: Valuing rental guarantee offered for units in Grande Towers

The table below lists three apartments from the “Sun” Tower in the Grande Towers Complex.  The data has been taken from the developer’s web site. I have taken the smallest units of 1BHK and 2BHK apartments and applied the lowest guarantee from the range provided in the advertisement given in Figure 1.   What this analysis shows is that the value of the guarantee is not proportionate with your investment. Value per square feet of investment declines significantly as you move up the value amount of the investments.  The guarantee for the most expensive apartment is only 39% in per square feet terms of the guarantee of the least expensive apartment.  This is primarily because the rate of return of your investment during the guarantee period declines from 8.31% for the 1BHK apartment to 5.90% for the most expensive apartment. So what this is telling is that if you want to invest in Grande Towers and take advantage of the guarantee, you want to look at the smaller units. For the 1BHK apartment in our analysis, you might also be better off paying only 23.2 lakhs and giving a lease for the developer for five years at the guaranteed rent.

 

Of three components mentioned above, we have calculated only on the first.  How do we go about calculating the expected cash flows and the resulting valuation of the other two components?  This is where all the risk of the potential investor lies.  As I mentioned above your expected rentals after the guarantee is over will depend on a variety of factors but most likely due to competitive pressures it will be less than what the guarantee is offering you now.  Keep in mind that the rentals envisioned for these apartments means that your target pool of potential renters is very small. Similarly the sale price will also depend on a variety of factors and as I mentioned earlier, unless the property is in a location or becomes a branded property such that there will always excess demand over supply, the sale value for old apartments will decline again due to competitive pressures.  You also need to take into account of the fact that the apartments will be vacant for some portion of your holding period.  Furthermore, we have not even looked at taxes, other charges and maintenance costs that you might have to pay during the holding period.  Keep in mind also that the present value of cash flows decline significantly as you move into the future. So the same one year rental income received say ten years from now will be much lower than the rental income received in the first year.

We will not go into this exercise but what I would like to point out is that the basic decision you will be making is whether the present value of your rental income and sale of property after the completion of the guarantee period will be in excess of your net investment with exercise of the guarantee given in column 5 for these three units.   Let me emphasize that I have assumed that you can immediately exercise the guarantee and give the developer the unit on lease for five years on payment of the net price.   If the fine print does not permit this then that brings additional uncertainty.

So how can developers afford to give these guarantees?  To get an idea of this let us look at the valuation from a developer’s perspective.  For the developer also the value of the sale of apartment again consists of three components: (a) the initial sale price (column 3), (b) the value of the guarantee it is offering (column 5) and the expected rental income during the guarantee period.  For the developer there is less uncertainty relative to the investor.  The minimum value is the net price with exercise of guarantee (column 5).  This occurs only if the developer is not able to rent out the apartment at all during the guarantee period which is hardly going to be the case.  The developer can rent at half the guarantee price and still recover 50% of the guarantee value that it has offered.

For a developer who has already priced in a high margin in the initial sale price, the guarantee will make a partial recoverable dent on the initial expected margin.  If the initial margin was say 50%, then the developer is still better off.   For the developer who is being financed by a bank loan, it is in its interest to quickly offload the apartment and pay back the debt even if it means getting a lower rate of return.  The consequences of not paying debt on time is much larger than stalling for a higher margin on the sale of apartments.

My advice to potential investors is to do your proper due diligence before purchasing any real estate units especially apartments before putting your hard earned money into one of them.  The last thing you want is to be an owner of a white elephant:  a high priced-apartment that you can neither rent nor sell and whose value will decline over time.

What’s in a USD PPA (Power Purchasing Agreement)?

Recently, I came across two articles one in the Kathmandu Post (KP) and the other in Republica.  The KP article stated that NEA (Nepal Electricity Authority) was amenable to US dollar (USD) PPA in certain conditions and made note of the claims by Nepalese investors in the sector that USD PPAs were essential for attracting foreign investors.  The Republica article mentioned that NRB Governor Dr. Khatiwada was against USD PPA for export oriented projects with investment from non-Indian third countries.  He made the argument that the current level of reserves made USD PPAs for such projects unsustainable and went as far as to say that it could lead to the devaluation of our currency with India, a veiled reference to that the fact the Indian currency peg is currently being supported by the sale of US dollars which could be quickly depleted by these USD PPA obligations if they mushroom. This is not the first time USD PPAs have been in the news and nor will this be the last time.  But what is it, in a dollar PPA, which makes one side claim that it is necessary and the other side that it is unsustainable for the country?

Put simply it is all about the management of foreign currency risk a project is exposed to.  Whenever we talk about a power project today, we are taking about five stakeholders: the government, the equity investor, the debt investor, NEA currently the sole purchaser for electricity for domestic consumption, and finally the consumer.  Foreign investors can come into the equation either as equity investors or debt investors.  Similarly we can have foreign consumers, primarily India, for export oriented projects. A recent article in the Himalayan Times also suggest that Bangladesh is also keen to purchase electricity from Nepal.

Let us begin by looking at several ownership structures and the relevance of USD PPAs with respect to them.

Case 1: Fully domestically owned, domestically financed project supplying the domestic market

The only FX risk these projects have is when they purchase capital instruments or have service contracts for the construction of the projects with foreigners.  The market risk exist only during the construction phase and until the contract terms are honored via payment of necessary amounts.  There is a convertibility risk, that is dollar funds may not be provided by the central bank when it is needed but this risk has very little to do with currency denomination of the PPA.  It should therefore be very clear that these type of projects do not require a USD PPA.

Case 2: Projects with domestic and foreign equity investors, domestically financed and supplying the domestic market only

 From an accounting perspective, these project faces the same risk as projects in Case 1 since the equity investment by the foreign investor will be converted to Nepalese rupees at time of the set-up of the company and each time the equity is called.  The foreign equity stakeholder however does face FX risk on its equity investment and any dividends that it might receive.  However, this investment is no different from the large portfolio investments that funds make in foreign companies by purchasing equity in the local stock markets.  The risk of translation of exited investments and any dividends received during the holding period of the investment is all borne by the investor.  So if a foreign equity investor wants to come to Nepal to invest in a hydro power project that sells its electricity in the domestic market, then while the investor should be comfortable that the investment made and dividends received can be converted to a globally traded currency and repatriated, the investor should also be willing to take all the business and operating risk of running the firm in Nepal which includes taking the risk that his dividends and investments while positive in Nepalese terms may be less in the home currency terms of the investor at time of repatriation.  Otherwise Coca Cola should be demanding that it be able to sell its product in USD terms.  

However this comparison with Coca Cola is not fully correct since Coca Cola can change its price structure to the end consumer to reflect its changing cost structure, while a hydropower project cannot unless it has captive buyers and can operate independently.    Despite the differences, it still makes little sense to have USD PPAs for these type of projects.  Somewhere I read a comment what the impact would have been to foreign investors by the devaluation of Nepalese Rupee from 70 to almost 100 now had they invested.  We should note that NPR devaluation is as a result of Indian Rupee (INR) devaluation and all foreign equity investors who had FDI in India or bought stocks of Indian firms in the Indian stock exchanges were impacted by the devaluation.  We should also mention what if the currency had appreciated from 70 to 50.  Who would have benefited then?  Equity investors have to take the movement of FX rates in stride since that is part and parcel of operating a business in foreign countries.

Case 3: Projects with foreign and domestic debt investors supplying the domestic market only.

It is highly unlikely that a foreign debt investor (except probably the World Bank that will be issuing a Nepalese denominated debt) in a Nepalese hydro power project will invest in local currency debt issued by any project.  If they do invest, they will insist that it be denominated either in their home currency or a globally tradable currency such as the USD.

Unlike equity invested in foreign currency which appears on a projects’ balance sheet in local currency terms, foreign debt if permitted by national government, appears on the balance sheet of projects in the currency of the debt. For simplicity let us say that this is in USD. Whenever there is USD debt on the balance sheet, the project’s outstanding debt obligation in local currency will fluctuate depending on the level of the FX rate.  Similarly, the firms interest payments and possible principal repayment in terms of NPR will also fluctuate. This market risk to FX, as opposed to convertibility risk that all foreign investments are subject to, will exist as long as the debt in USD are outstanding.  Once completely paid, the project is no longer subject to the FX market risk. Obviously the equity investors remain and their investment will be subject to both market risk and convertibility risk but they will be no different from the risk that foreign investors were subject to in Case 2. 

This suggest some boundary rules in the construction of any PPA agreement with foreign investment.  If the objective of the USD PPA is to ensure that projects are able to pay the interest and principal repayment obligation of their foreign currency debt, then any pricing arrangement should be a weighted component of local and USD PPA price.  For lack of a better measure this could be the foreign debt to total financing (debt + equity) ratio.  The applicable term of any USD component of the pricing agreement should not exceed the maturity of the longest USD debt, that is, after the USD debt matures all prices of electricity should be in local terms.  Similarly, the weight of the USD component of the pricing should decline as the outstanding level of foreign debt declines.  We will look at an example on how this might work later.

Case 4: Projects with foreign or domestic equity and debt investment with no sale to domestic consumers

Since the electricity is not being generated for local consumption, a USD or NPR PPA is moot in this situation. The government definitely has a role to play through the signing of a power development agreement to facilitate the trade of electricity across borders and encourage such investments since they will be the direct beneficiary of tax and royalty receipts which can be invested for the larger good of the country.  IPPs who want to sell their electricity to third countries will actually have to sign a transmission agreement which will require them to pay for the usage of the transmission infrastructure to get their electricity to the targeted countries.  Should the domestic market require electricity from such projects, then domestic distributors may enter into supply agreements with such producers in mutually agreed terms which could be in local currency or USD if permitted by the country’s regulations.  Assuming that these will be short term in nature, the impact of such agreements whether in local or USD terms would not be the same as signing of long term USD PPAs.

Case 5: Projects with foreign or domestic debt investment with partial sale to domestic consumers

Case 3 analysis would be applied here but only for the portion that is targeted to domestic investors.  Ad hoc extra purchases can be made based on contractual terms that is not part of the PPA agreement targeted for domestic consumption as mentioned in Case 4.

How could we structure a USD PPA based on the analysis presented in Case 3? 

The first step would be to calculate what the PPA price per unit of electricity would be under two scenarios: In scenario 1, the PPA would be entirely in local terms for the duration of the concession.  In Scenario 2, the PPA would be entirely in USD terms for the duration of the concession.  

Figure 1: Deconstructing a USD PPA

We should keep in mind that when an IPP asks for a USD price for its electricity, then in effect the purchaser (NEA) is giving the IPP an FX guarantee. The IPP could get PPA in Nepalese rupee and then buy an FX contract simultaneously to sell NPR rupees for USD in the market.  Thus, the USD PPA can be thought of as two contracts (see Figure 1): Contract 1 where NEA agrees to purchase electricity in NPR and Contract 2 where NEA agrees to repurchase the NPR from the IPP based on Contract 1 and provide USD in return.  The second contract is a long-term FX contract which has cost associated with it and NEA should charge the IPP for providing it.   Let us for simplicity assume that the local currency PPA is 8 rupees per unit.  Then in current USD terms it would be 8 cents on the dollar assuming 1 USD = 100 rupees.  Now let us assume that the cost of providing the embedded FX contract is 3 cents per unit, then an equivalent USD PPA would be 5 cents per unit.  Please note that there are methods to calculate what the cost of FX contract would be using the relationship between NPR and INR and INR and USD but this is beyond the scope of this article.

Next let us determine what the foreign debt to total financing ratio is.  Let us say that equity is 30%, and that debt is equally divided between foreign and domestic.  So the foreign debt ratio is 35%. 

Now we have all the components to structure a simple PPA agreement that incorporates the above scenario.  If payments between NEA and IPP are done monthly, then we an essentially have a clause that says that of the monthly output purchased by NEA, 35% would be at paid in USD at 5 cents per unit and the remaining 65% at 8 rupees per unit.  USD debt to total outstanding financing ratio would be revised at the beginning of each fiscal year. Price escalation clauses in the PPA would be applied to both components. This will also ensure that once the USD debt component is paid, the PPA price will only be in local currency terms.

Table 1 provides a formulaic view and a worked out example.

Table 1: Formulaic and worked out example of how a PPA could be structured

Assume
Qym	Amount of electricity sold by IPP to NEA in month m in year y in kilowatt hours.	10.4 million KWh
P($,ym)	Price per unit of electricity in $ for month m in year y.	0.05 cents (starting year)
P(N,ym)	Price per unit of electricity in Rupees for month m in year y.	8 NPR (starting year)
D($,y)	debt in $ at beginning of year y.	17,500,000 USD (staring year)
D(N,y)	Debt in NPR at beginning of year y.	1,750,000,000 NPR (starting year)
E(N,y)	Equity in NPR at beginning of year y)	1,500,000,000 NPR (starting year)
X($N,y)	exchange rate for one USD in NPR at beginning of year y.	Assume 1 USD = 100 NPR (starting year)
R($,y)	Ratio of USD debt to total financing = D($,y) * X($N,y) / [ D($,y) * X($N,y) + D(N,y) + E(N,y)]	= 17,500,000 x 100 / (17,500,000 x 100 + 1,750,000,000 + 1,500,000,000) = 35%
USD Payment	R($,y) * Qym * P($,ym)	0.35 x 10,400,000 x 0.05 = 182,000 USD
NPR Payment	[1 – R($,y)] * Qym * P(N,ym)	(1-0.35) x 10,400,000 x 8 = 54,080,000 NPR

Note: the worked out example is based on a 25MW plant that costs 2 million USD per MW to build.  This would require 50 million USD to build implying 15 million USD or 1.5 billion NPR in equity investment, 17.5 million USD in foreign debt, and 1.75 billion NPR in local debt.  Turbine operates 24 hours 365 days with an average efficiency of 57%.  These assumptions may not reflect reality and are being used just for exposition purpose.

How NEA could hedge its FX exposure from USD PPA?

Now that we have looked at how NEA could structure a PPA with the IPPs, let us also look at how it can manage the fluctuations that will result as a result of a part of its expense stream being in USD.  First of all, the NPR is not a globally traded currency and so there is no real market mechanism for NEA to hedge its risk.  However there does appear to be an active USD and Indian rupee forward market.  Given that NPR is pegged to the US dollar, NRB regulations permitting, NEA could use the INR market to hedge its foreign currency exposure as a result of the USD PPA on a short term, say one year, rolling basis. 

Every year as part of its planning process, the NEA could estimate how much payments in USD it will have to make with respect to all of its obligations to IPPs.  It could then enter into hedge contracts with Indian banks or even Nepalese banks (regulations permitting) to sell INR to get USD.  There is a big assumption here that NRB will give INR against NPR for NEA to sell to its FX counterparties to honor its obligations).  Any excess cost as a result of the hedge would then be rolled out to its consumers on a proportionate basis with a revision in prices at the beginning of each year.  If NRB is unwilling, then NEA can still do the exercise of what its cost to put in a one year hedge on its USD commitments and could roll out the anticipated excess cost with a price revision. In this case NEA will bear the cost or benefit of the price revision, i.e. if the dollar appreciates more than anticipated, NEA will have a loss even with the price revision but if dollar rates appreciate less than anticipated, the NEA benefits with the price revision for the given year.

Obviously, this also anticipates that there is political will to deregulate electricity price control.  If the government wants to control the price of electricity and provide consumers with a floor on electricity prices, it is essentially asking NEA to provide them a guarantee similar to IPPs asking for a USD PPA.  If that is the case, then it should also be willing to pay for the cost associated with it. I do not believe that it would be very difficult to structure a price mechanism whereby price increases are kept to minimum or zero for low-end user and prices rise rapidly as usage increase.  Essentially if you want to use more electricity then you will have to pay more with the marginal cost of electricity per unit rising much more rapidly with each threshold. 

Finally, I would like to note that while I have stated that USD equity investment should not be considered when determining the ratio on which to apply the USD rate for electricity, this should not be construed that I am against it.  It can be incorporated if it is in the interest of the country to see the project go through.  I am pretty sure that if we all put our heads together that we can easily come to a solution that can solve our electricity crisis starting with how a PPA is structured.  There is no need to be for or against it.  A market mechanism can be constructed to create a win-win situation for all.