Options and Warrants
When Property companies obtain financing there are often complex financing structures that are built into package and one of the ways the Developer or property company can make the arrangement more appealing to the lenders or investors is to offer options or warrants on the financing.
To begin with lets explainwhat an option is. Suppose company Focusnet has shares that are quoted at 500p in the stock market. If you think that there is a very good change that the shares will rise to 600p in the stock market. You could buy the shares themselves which would require quite a bit of cash or you could by an option giving you the right to buy. one stock f company at at say 530p at any time in the next 3 months. (530 would therefore be the strike price for this option)
Lets say for example you paid 30p for this option. If the stock price rises to 550p, there would be value in the option because you could immediately buy the shares for 530p and sell them for 550p and pocket a profit of 20p per share. But you would still have a loss because you paid 30p for the option in beginning so you would therefore have a loss of 10p I company A stock rises to 560p you would be breaking even and if it rises to 600p you would have a profit of (600p - 530p - 30p = 40p profit. on an investment of 30p. This would be a return of over 100% for the buyer of the option. As you see the share price also rose a much smaller percentage than this. Of course if the share price fell beloe 530p the option would expire worthless and the investor would lose his investment. The seller of the option however is probably taking a different view of the stock. He believes that stock price is going to go down stay the same. This is whats known as a call option but there are also put options which hives the purchaser the right to sell the option at a predetermined price. This would be used if the purchaser believes the stock is going to go down in price. In the Uk options can be bought and sold on the traded options market. Another important point regarding options is that they are not created by the property company. So if you buy an option on Company As stock. The money would go to the seller of the option, not to company A.
Warrants differ from options in that they are created by the company itself. To illustrate lets say company wants to raise cash now it decides to sell warrants giving the purchaser the right to subscribe for new shares at a fixed price in the future. Now lets say that the terms of the warrant are the same as the previous example. In this case Company a would ger 30p for each warrant plus 530p per share for each share it sold. This probably would only occur if the share price exceeded 530p to make the purchase worthwhile to the holder of the options. These warrants would also be traded in the stock market. typically warrants also have a much longer life than a traditional option often running into several years while a traditional options life can be anywhere from 1 to 9 months.
Now that we know what warrants and options are we can see how they might be used by a property developer or a property company as tools to raise cash and cheapen the cost of borrowing. For example lets say property company Focusnet want so issue a fixed interest bond but in order to make the bond but in order to lower the interest rate decides to offer 1 warrant giving the buyer the right to purchase a Company A share with every £5 of bond value. In another instance a warrant could be used to give the buyer the right to buy more bonds in the future. This would therefore be a bet on future interest rates for the buyer.
Now to illustrate further lets consider the case of the convertible bond. lets say Focusnet's stock is trading at 400p with a 10% coupon and lets say that that Focusnets decides to issue a convertible at 500p. In other words each 500p bond converts to one Focusnet stock. Therefore an investor is buying 2 things a bond that pays 10% per year and second an option to purchase 1 share of Focusnet for 500p.
Another type of bond is known as a premium put convertible and we will use an example to illustrate. Lets say a Focusnet issues a bond with a 500p conversion and a 5% yield that converts into 1 Focusnet stock if the stock price reaches this price. However in order to appeal to investors which maybe are more concerned about yield than shares, it offers the opportunity of a 10% yield on the bonds. It does this by agreeing to buy back the bonds at a higher price than 500p at say some point in the future say 5 years at a price which would equate to a 10% return over five years. Now lets say that for Example that Focusnets shares rise to 530 in the next 5 years it might be better for the investor to sell the bond back to the company at a the higher predetermined price as this will result in a greater return for the investor.
One disadvantage of this strategy however is that often property company such as Focusnet is planning on the likelyhood that the convertible bond will become permanent share capital given enough time. Hoever problems may arise if the share price does not move up as expected. So the company might have to offer incentives to the investor on top of the conversion ratio to entire him to retain the bonds.