An analysis of commercial real estate returns: is there a smoothing puzzle?

In this paper we investigate the commonly used autoregressive filter method of adjusting appraisal-based real estate returns to correct for the perceived biases induced in the appraisal process. Since the early work by Geltner (1989), many papers have been written on this topic but remarkably few have considered the relationship between smoothing at the individual property level and the amount of persistence in the aggregate appraised-based index. To investigate this issue in more detail we analyse a sample of individual property level appraisal data from the Investment Property Database (IPD). We find that commonly used unsmoothing estimates overstate the extent of smoothing that takes place at the individual property level. There is also strong support for an ARFIMA representation of appraisal returns.

Systematic property risk: quantifying UK property betas 1983-2005

The increased frequency in reporting UK property performance figures, coupled with the acceptance of the IPD database as the market standard, has enabled property to be analysed on a comparable level with other more frequently traded assets. The most widely utilised theory for pricing financial assets, the Capital Asset Pricing Model (CAPM), gives market (systematic) risk, beta, centre stage. This paper seeks to measure the level of systematic risk (beta) across various property types, market conditions and investment holding periods. This paper extends the authors’ previous work on investment holding periods and how excess returns (alpha) relate to those holding periods. We draw on the uniquely constructed IPD/Gerald Eve transactions database, containing over 20,000 properties over the period 1983-2005. This research allows us to confirm our initial findings that properties held over longer periods perform in line with overall market performance. One implication of this is that over the long-term performance may be no different from an index tracking approach.

Real estate portfolio size and risk reduction

The reduction of portfolio risk is important to all investors but is particularly important to real estate investors as most property portfolios are generally small. As a consequence, portfolios are vulnerable to a significant risk of under-performing the market, or a target rate of return and so investors may be exposing themselves to greater risk than necessary. Given the potentially higher risk of underperformance from owning only a few properties, we follow the approach of Vassal (2001) and examine the benefits of holding more properties in a real estate portfolio. Using Monte Carlo simulation and the returns from 1,728 properties in the IPD database, held over the 10-year period from 1995 to 2004, the results show that increases in portfolio size offers the possibility of a more stable and less volatile return pattern over time, i.e. down-side risk is diminished with increasing portfolio size. Nonetheless, increasing portfolio size has the disadvantage of restricting the probability of out-performing the benchmark index by a significant amount. In other words, although increasing portfolio size reduces the down-side risk in a portfolio, it also decreases its up-side potential. Be that as it may, the results provide further evidence that portfolios with large numbers of properties are always preferable to portfolios of a smaller size.

Valuation accuracy: reconciling the timing of the valuation and sale

Carsberg (2002) suggested that the periodic valuation accuracy studies undertaken by, amongst others, IPD/Drivers Jonas (2003) should be undertaken every year and be sponsored by the RICS, which acts as the self-regulating body for valuations in the UK. This paper does not address the wider issues concerning the nature of properties which are sold and whether the sale prices are influenced by prior valuations, but considers solely the technical issues concerning the timing of the valuation and sales data. This study uses valuations and sales data from the Investment Property Databank UK Monthly Index to attempt to identify the date that sale data is divulged to valuers. This information will inform accuracy studies that use a cut-off date as to the closeness of valuations to sales completion date as a yardstick for excluding data from the analysis. It will also, assuming valuers are informed quickly of any agreed sales, help to determine the actual sale agreed date rather than the completion date, which includes a period of due diligence between when the sale is agreed and its completion. Valuations should be updated to this date, rather than the formal completion date, if a reliable measure of valuation accuracy is to be determined. An accuracy study is then undertaken using a variety of updating periods and the differences between the results are examined. The paper concludes that the sale only becomes known to valuers in the month prior to the sale taking place and that this assumes either that sales due diligence procedures are shortening or valuers are not told quickly of agreed sale prices. Studies that adopt a four-month cut-off date for any valuations compared to sales completion dates are over cautious, and this could be reduced to two months without compromising the data.

Appraiser behaviour and appraisal smoothing: some qualitative and quantitative evidence

There is a substantial literature which suggests that appraisals are smoothed and lag the true level of prices. This study combines a qualitative interview survey of the leading fund manager/owners in the UK and their appraisers with a empirical study of the number of appraisals which change each month within the IPD Monthly Index. The paper concentrates on how the appraisal process operates for commercial real estate performance measurement purposes. The survey interviews suggest that periodic appraisal services are consolidating in fewer firms and, within these major firms, appraisers adopt different approaches to changing appraisals on a period by period basis, with some wanting hard transaction evidence while others act on ‘softer’ signals. The survey also indicates a seasonal effect with greater effort and information being applied to annual and quarterly appraisals than monthly. The analysis of the appraisals within the IPD Monthly Index confirms this effect with around 5% more appraisals being moved at each quarter day than the other months. More November appraisals change than expected and this suggests that the increased information flows for the December end year appraisals are flowing through into earlier appraisals, especially as client/appraiser draft appraisal meetings for the December appraisals, a regular occurrence in the UK, can occur in November. January illustrates significantly less activity than other months, a seasonal effect after the exertions of the December appraisals.

Hedging effectiveness of total returns swaps: application to the Japanese market

The development of the real estate swap market offers many opportunities for investors to adjust the exposure of their portfolios to real estate. A number of OTC transactions have been observed in markets around the world. In this paper we examine the Japanese commercial real estate market from the point of view of an investor holding a portfolio of properties seeking to reduce the portfolio exposure to the real estate market by swapping an index of real estate for LIBOR. This paper explores the practicalities of hedging portfolios comprising small numbers of individual properties against an appropriate index. We use the returns from 74 properties owned by Japanese Real Estate Investment Trusts over the period up to September 2007. The paper also discusses and applies the appropriate stochastic processes required to model real estate returns in this application and presents alternative ways of reporting hedging effectiveness. We find that the development of the derivative does provide the capacity for hedging market risk but that the effectiveness of the hedge varies considerably over time. We explore the factors that cause this variability.