Depreciation and its impact on the total return of UK commercial real estate, 1994-2003

Depreciation is a key element of understanding the returns from and price of commercial real estate. Understanding its impact is important for asset allocation models and asset management decisions. It is a key input into well-constructed pricing models and its impact on indices of commercial real estate prices needs to be recognised. There have been a number of previous studies of the impact of depreciation on real estate, particularly in the UK. Law (2004) analysed all of these studies and found that the seemingly consistent results were an illusion as they all used a variety of measurement methods and data. In addition, none of these studies examined impact on total returns; they examined either rental value depreciation alone or rental and capital value depreciation. This study seeks to rectify this omission, adopting the best practice measurement framework set out by Law (2004). Using individual property data from the UK Investment Property Databank for the 10-year period between 1994 and 2003, rental and capital depreciation, capital expenditure rates, and total return series for the data sample and for a benchmark are calculated for 10 market segments. The results are complicated by the period of analysis which started in the aftermath of the major UK real estate recession of the early 1990s, but they give important insights into the impact of depreciation in different segments of the UK real estate investment market.

Capturing UK real estate volitility

Volatility, or the variability of the underlying asset, is one of the key fundamental components of property derivative pricing and in the application of real option models in development analysis. There has been relatively little work on volatility in real terms of its application to property derivatives and the real options analysis. Most research on volatility stems from investment performance (Nathakumaran & Newell (1995), Brown & Matysiak 2000, Booth & Matysiak 2001). Historic standard deviation is often used as a proxy for volatility and there has been a reliance on indices, which are subject to valuation smoothing effects. Transaction prices are considered to be more volatile than the traditional standard deviations of appraisal based indices. This could lead, arguably, to inefficiencies and mis-pricing, particularly if it is also accepted that changes evolve randomly over time and where future volatility and not an ex-post measure is the key (Sing 1998). If history does not repeat, or provides an unreliable measure, then estimating model based (implied) volatility is an alternative approach (Patel & Sing 2000). This paper is the first of two that employ alternative approaches to calculating and capturing volatility in UK real estate for the purposes of applying the measure to derivative pricing and real option models. It draws on a uniquely constructed IPD/Gerald Eve transactions database, containing over 21,000 properties over the period 1983-2005. In this first paper the magnitude of historic amplification associated with asset returns by sector and geographic spread is looked at. In the subsequent paper the focus will be upon model based (implied) volatility.

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.

The underlying return generating factors for REIT returns: an application of independent component analysis

Multi-factor approaches to analysis of real estate returns have, since the pioneering work of Chan, Hendershott and Sanders (1990), emphasised a macro-variables approach in preference to the latent factor approach that formed the original basis of the arbitrage pricing theory. With increasing use of high frequency data and trading strategies and with a growing emphasis on the risks of extreme events, the macro-variable procedure has some deficiencies. This paper explores a third way, with the use of an alternative to the standard principal components approach – independent components analysis (ICA). ICA seeks higher moment independence and maximises in relation to a chosen risk parameter. We apply an ICA based on kurtosis maximisation to weekly US REIT data using a kurtosis maximising algorithm. The results show that ICA is successful in capturing the kurtosis characteristics of REIT returns, offering possibilities for the development of risk management strategies that are sensitive to extreme events and tail distributions.

Lease maturity and initial rent: is there a term structure for UK commercial property leases?

This paper investigates the relationship between lease maturity and rent in commercial property. Over the last decade market-led changes to lease structures, the threat of government intervention and the associated emergence of the Codes of Practice for commercial leases have stimulated growing interest in pricing of commercial property leases. Seminal work by Grenadier (1995) derived a set of hypotheses about the pricing of different lease lengths in different market conditions. Whilst there is a compelling theoretical case for and a strong intuitive expectation of differential pricing of different lease maturities, to date the empirical evidence is inconclusive. Two Swedish studies have found mixed results (Gunnelin and Soderbergh 2003 and Englund et al 2003). In only half the cases is the null hypothesis that lease length has no effect rejected. In the UK, Crosby et al (2003) report counterintuitive results. In some markets, they find that short lease terms are associated with low rents, whilst in others they are associated with high rents. Drawing upon a substantial database of commercial lettings in central London (West End and City of London) over the last decade, we investigate the relationship between rent and lease maturity. In particular, we test whether a building quality variable omitted in previous studies provides empirical results that are more consistent with the theoretical and intuitive a priori expectations. It is found that initial leases rates are upward sloping with the lease term and that this relationship is constant over time.

Private property vehicles: the valuation of interests in limited partnerships

This paper examines the extent to which the valuation of partial interests in private property vehicles should be closely aligned to the valuation of the underlying assets. A sample of vehicle managers and investors replied to a questionnaire on the qualities of private property vehicles relative to direct property investment. Applying the Analytic Hierarchy Process (AHP) technique the relative importance of the various advantages and disadvantages of investment in private property vehicles relative to acquisition of the underlying assets are assessed. The results suggest that the main drivers of the growth of the this sector have been the ability for certain categories of investor to acquire interests in assets that are normally inaccessible due to the amount of specific risk. Additionally, investors have been attracted by the ability to ‘outsource’ asset management in a manner that minimises perceived agency problems. It is concluded that deviations from NAV should be expected given that investment in private property vehicles differs from investment in the underlying assets in terms of liquidity, management structures, lot size, financial structure inter alia. However, reliably appraising the pricing implications of these variations is likely to be extremely difficult due to the lack of secondary market trading and vehicle heterogeneity.

Flight to quality? An investigation of the attributes of sold properties in hot and cold markets

This paper uses sales transaction data in order to examine whether flight from risk phenomena took place in the US office property investment market during the financial crisis of 2007-2009. The effect of the crisis on the pricing of property quality attributes, mainly summarized by the class category of each building, is investigated. In addition, the paper examines how turnover levels were affected by the market downturn and whether there were significant variations between different real estate quality types. The results of the hedonic regression models suggest that the price spread between Class, A, B and C grew significantly during the downturn. We also find that property attributes such as size, height and age are priced significantly different in ‘hot’ and ‘cold’ markets.

The elasticity of demand is about occupancy, not prices: building European demand curves based on occupancy elasticity

The peak congestion of the European grid may create significant impacts on system costs because of the need for higher marginal cost generation, higher cost system balancing and increasing grid reinforcement investment. The use of time of use rates, incentives, real time pricing and other programmes, usually defined as Demand Side Management (DSM), could bring about significant reductions in prices, limit carbon emissions from dirty power plants, and improve the integration of renewable sources of energy. Unlike previous studies on elasticity of residential electricity demand under flat tariffs, the aim of this study is not to investigate the known relatively inelastic relationship between demand and prices. Rather, the aim is to assess how occupancy levels vary in different European countries. This reflects the reality of demand loads, which are predominantly determined by the timing of human activities (e.g. travelling to work, taking children to school) rather than prices. To this end, two types of occupancy elasticity are estimated: baseline occupancy elasticity and peak occupancy elasticity. These represent the intrinsic elasticity associated with human activities of single residential end-users in 15 European countries. This study makes use of occupancy time-series data from the Harmonised European Time Use Survey database to build European occupancy curves; identify peak occupancy periods; draw time use demand curves for video and TV watching activity; and estimate national occupancy elasticity levels of single-occupant households. Findings on occupancy elasticities provide an indication of possible DSM strategies based on occupancy levels and not prices.

Demand response experience in Europe: policies, programmes and implementation

Over the last few years, load growth, increases in intermittent generation, declining technology costs and increasing recognition of the importance of customer behaviour in energy markets have brought about a change in the focus of Demand Response (DR) in Europe. The long standing programmes involving large industries, through interruptible tariffs and time of day pricing, have been increasingly complemented by programmes aimed at commercial and residential customer groups. Developments in DR vary substantially across Europe reflecting national conditions and triggered by different sets of policies, programmes and implementation schemes. This paper examines experiences within European countries as well as at European Union (EU) level, with the aim of understanding which factors have facilitated or impeded advances in DR. It describes initiatives, studies and policies of various European countries, with in-depth case studies of the UK, Italy and Spain. It is concluded that while business programmes, technical and economic potentials vary across Europe, there are common reasons as to why coordinated DR policies have been slow to emerge. This is because of the limited knowledge on DR energy saving capacities; high cost estimates for DR technologies and infrastructures; and policies focused on creating the conditions for liberalising the EU energy markets.

Modelling the implied volatility of options on long gilt futures

This paper investigates the properties of implied volatility series calculated from options on Treasury bond futures, traded on LIFFE. We demonstrate that the use of near-maturity at the money options to calculate implied volatilities causes less mis-pricing and is therefore superior to, a weighted average measure encompassing all relevant options. We demonstrate that, whilst a set of macroeconomic variables has some predictive power for implied volatilities, we are not able to earn excess returns by trading on the basis of these predictions once we allow for typical investor transactions costs.

Can we explain the dynamics of the UK FTSE 100 stock and stock index futures markets?

If stock and stock index futures markets are functioning properly price movements in these markets should best be described by a first order vector error correction model with the error correction term being the price differential between the two markets (the basis). Recent evidence suggests that there are more dynamics present than should be in effectively functioning markets. Using self-exciting threshold autoregressive (SETAR) models, this study analyses whether such dynamics can be related to different regimes within which the basis can fluctuate in a predictable manner without triggering arbitrage. These findings reveal that the basis shows strong evidence of autoregressive behaviour when its value is between the two thresholds but that the extra dynamics disappear once the basis moves above the upper threshold and their persistence is reduced, although not eradicated, once the basis moves below the lower threshold. This suggests that once nonlinearity associated with transactions costs is accounted for, stock and stock index futures markets function more effectively than is suggested by linear models of the pricing relationship.

Internal rents and corporate property management: a study into the use of internal rents in UK corporate organisations

Research in the late 1980s showed that in many corporate real estates users were not fully aware of the full extent of their property holdings. In many cases, not only was the value of the holdings unknown, but there was uncertainty over the actual extent of ownership within the portfolio. This resulted in a large number of corporate occupiers reviewing their property holdings during the 1990s, initially to create a definitive asset register, but also to benefit from an more efficient use of space. Good management of corporately owned property assets is of equal importance as the management of other principal resources within the company. A comprehensive asset register can be seen as the first step towards a rational property audit. For the effective, efficient and economic delivery of services, it is vital that all property holdings are utilised to the best advantage. This requires that the property provider and the property user are both fully conversant with the value of the property holding and that an asset/internal rent/charge is made accordingly. The advantages of internal rent charging are twofold. Firstly, it requires the occupying department to “contribute” an amount to the business equivalent to the open market rental value of the space that it occupies. This prevents the treating of space as a free good and, as individual profit centres, each department will then rationalise its holdings to minimise its costs. The second advantage is from a strategic viewpoint. By charging an asset rent, the holding department can identify the performance of its real estate holdings. This can then be compared to an internal or external benchmark to help determine whether the company has adopted the most efficient tenure pattern for its properties. This paper investigates the use of internal rents by UK-based corporate businesses and explains internal rents as a form of transfer pricing in the context of management and responsibility accounting. The research finds that the majority of charging organisations introduced internal rents primarily to help calculate true profits at the business unit level. However, less than 10% of the charging organisations introduced internal rents primarily to capture the return on assets within the business. There was also a sizeable element of the market who had no plans to introduce internal rents. Here, it appears that, despite academic and professional views that internal rents are beneficial in improving the efficient use of property, opinion at the business and operational level has not universally accepted this proposition.

Real options and game theoretical approaches to real estate development projects: multiple equilibria and the implications of different tie-breaking rules

This paper contributes to a fast growing literature which introduces game theory in the analysis of real option investments in a competitive setting. Specifically, in this paper we focus on the issue of multiple equilibria and on the implications that different equilibrium selections may have for the pricing of real options and for subsequent strategic decisions. We present some theoretical results of the necessary conditions to have multiple equilibria and we show under which conditions different tie-breaking rules result in different economic decisions. We then present a numerical exercise using the in formation set obtained on a real estate development in South London. We find that risk aversion reduces option value and this reduction decreases marginally as negative externalities decrease.

Office rent determinants: a hedonic panel analysis

It has been frequently observed that office markets are subject to particularly high fluctuations in rents and vacancy levels, thus exposing real estate investors to considerable risk regarding expected future income streams. This paper analyzes the determinants of office rents and their variability over time and across sub-markets to gain insight into the rent price formation and its stability across space and over time. No support is found for the single-market hypothesis which states that arbitrage opportunities effectively align real estate pricing schemes in various parts of city. Instead, the results suggest that the importance of hedonic pricing factors varies both over time and across submarkets.

The dynamics of asset prices and transaction activity in illiquid markets: the case of private commercial real estate

This paper investigates the relationship between capital flows, turnover and returns for the UK private real estate market. We examine a number of possible implication of capital flows and turnover on capital returns testing for evidence of a price pressure effect, ‘return chasing’ behaviour and information revelation. The main tool of analysis is a panel vector autoregressive (VAR) regression model in which institutional capital flows, turnover and returns are specified as endogenous variables in a two equation system in which we also control for macro-economic variables. Data on flows, turnover and returns are obtained for the 10 market segments covering the main UK commercial real estate sectors. Our results do not support the widely-held belief among practitioners that capital flows have a ‘price pressure’ effect. Although there is some evidence of return chasing behaviour, the short timescales involved suggest this finding may be due to delayed recording of flows relative to returns given the difficulties of market entry. We find a significant positive relationship between lagged turnover and contemporaneous capital returns, suggesting that asset turnover provides pricing information.