Real Estate Indexing:

Market Memo  

Real Estate Indexing:

Increasingly, Real Estate indices are used as a proxy for the private and highly illiquid real estate market. They are increasingly available; provide a range of geographies and industries and show closing prices on a consistent basis within an asset that often trades within non-transparent markets. Despite this, Real Estate Indices fail to provide a comparable representation of their underlying asset in the same fashion as publicly listed debt and equity investments. Subsequently, their overreliance may lead to unaccounted for risk exposure within real estate portfolios.

The challenges associated with using benchmarks to establish current and historical market conditions comes down to an accurate understanding of an asset’s underlying demand and subsequent pricing. Indexation and their liquid derivatives fall short of tracking these changes in real time due largely to their observation and measurement of Real Estate prices. Index’s attempt to compute real estate prices and returns through (1). Appraisals, (2). Financial market prices and (3). Adjusted privately traded prices or some combination there of. Assessing the intricacies of these methodologies warrants further and more in depth discussion, however in relation to active price tracking the illiquidity of the underlying assets still pose material challenges.

For Commercial properties the NCREIF Property Index (NPI), which can be found at is the most established and widely used index in the United States. The Index, published by the National Council of Real Estate Investment Fiduciaries (NCREIF) a not for profit industry organization, is derived from appraisals of its memberships properties. Quarterly, members of NCREIF are required to submit data regarding the value of their properties from which the prices of the index and sub-indexes (bifurcated by asset and geographic location) are computed.

Every Quarter members of NCREIF report the value of their assets based upon either DCF or the Comparable Sales method, the NPI is also reported every quarter however, NPI properties are not necessarily appraised every quarter. In fact, most properties are appraised once per year or once every two to three year periods. This largely results from the time, cost and energy required to conduct valuations and the requirement for appraisers to be paid. For members of NCREIF contributing to the NPI as well as for any other property owner, there is a balance between the cost and benefits. Instead of conducting and paying for frequent valuations it is not atypical for real estate owners to adjust past valuations to account for capital expenditures, often called “desktop appraisals.”

Even when appraisals are performed accurately and frequently, their use introduces the potential for data smoothing, which significantly alters the implied risk/return spectrum of the underlying assets. Data Smoothing occurs assessing returns when the prices used in have been dampened relative to the volatility of the real asset’s unobservable but underlying price. In the case of real estate, when appraisals are used in place of the asset’s true market value and provide dampened price changes, then the resulting return series persistently underestimates an understates the volatility of the true returns as well as their correlation with other asset classes within an investors portfolio.

For example, the NCREIF is calculated on an unleveraged basis as if the properties measured were acquired entirely with equity and no debt financing in order to reduce the volatility of their returns in relation to returns of real estate acquired with leverage. Subsequently, interest charges are not deducted. Additionally, NPI returns are calculated on a before tax basis and do not include income tax effects. Lastly, the returns are calculated on a property basis and then value-weighted for the index’s calculation where more highly valued properties receive a larger weighing. Data smoothing can be necessary to filter out white noise and irrelevant information but it is important to remember that it may also alter the nature of some significant takeaways.

It remains important to remember that appraisals conducted in any time series are not real time. They are always reflecting on a perceived value at particular period in time and since there is not the benefit of observing the future that period in time is always lagging. In addition to the potentially lagged nature of both the DCF and comparable properties approach being relatively backward looking, appraisals themselves maintain a very human element to their production making them highly susceptible to heuristics, biases and failures of judgment. In the case of appraisals, anchoring or the compulsion to overly rely on initial information further compounds challenges associated with the relevance of appraisals and data smoothing for indexation. In the case of appraisals it often manifests in the appraisers recollection of historical performance of a certain asset or geographic region without as much focus paid to current market conditions resulting in distorted prices between what is reported and what a buyer may be willing to offer. This may lead to inflated prices of real estate in a period of declining performance for the asset; alternatively it may lead to a compressed value during a period of growing market strength and increased demand.

The appraisal system itself is not real time and maintains an inherent lag and divergence to market prices that is amplified by the human element of return valuations. Although this is perfectly understandable considering the illiquidity of real estate, it often goes overlooked while assessing investment risk and portfolio performance. For example, assume you have two investments providing returns over five periods.

HPR Investment 1 Investment 2
1 -1.00% -2.00%
2 4.00% 3.00%
3 5.00% 4.00%
4 -2.00% -1.00%
5 2.00% 2.00%
Correlation 96.28%

Assessed side by side, these investment maintained a high degree of correlation with one another, that is to say their return distributions were comparable in both their timing and size. Now, assume that Investment 2 is a index based off of highly illiquid assets. The index has the exact same returns however; they are reported one period later due to illiquidity and appraisal lags.

HPR Investment 1 Investment 2
1 -1.00% 3.00%
2 4.00% 4.00%
3 5.00% -1.00%
4 -2.00% 2.00%
Correlation -35.14%

The true correlation between the returns of the two investments may be close to 96.28%. However, the measured correlations between the assets due to their lag is -35.14%. The underestimated correlation may indicate greater opportunities for diversification however, it also provides a glimpse at hidden portfolio risk.

Assessing risk-adjusted returns within the field of investment management is art as well as a science. Despite this, the imaginative necessity is often overlooked in relation to anything that maintains the illusion of objective facts. As an investment professional across any asset class, your expected to develop, underwrite and ultimately justify what is purchased, held and sold both at the time of entry as well as upon reversion (which in real estate can often be materially different). However at no point throughout an investment’s time horizon does the investor develop the ability to predict the future. Further complicating the matter, the leading indicators of the risk and return spectrum are established using historical information i.e. variance which ultimately shows not downside risk but deviation from the mean returns over whatever historical period is being examined. Real Estate Indexing does not create these conditions, however for institutional investors their ready availability greatly increases the tendency of fund managers to improperly allocate their exposure across asset classes.

Real Estate As An Investment: An Overview

Market Memo

For those new to P(Gain) we are not trying to convince you to invest in real assets, if your visiting our site, your likely already working within the field. Rather it is to provide what we see as context and more tellingly, our perspective of what we think are important characteristics about the asset class and characteristics about real assets within a broader portfolio.  

In the contemporary investment environment, Real Estate is considered an alternative investment for institutional investors and is often compared against equities, fixed income assets and cash holdings. Unfortunately, for many individual and passive investors their attention remains on more liquid markets with the memories of the 2007 financial crisis remaining vibrant. For context, As of June 2018, the IRA is 44 years old, the 401(K) has been in existence for 37 years and the Roth variations of either are coming up on their 21st birthday. Although the fundamentals of these programs are sound, their high exposure to financial assets as well as their lack of operational history provides adequate justification for the greater inclusion of real assets within one’s personal and institutional holdings.

Real Estate is an idiosyncratic investment. It maintains unique characteristics that influence its risky premium for both systemic and unsystemic factors but despite this, it has served as the largest source of wealth generation and distribution throughout history. In 2018, for many individuals and institutions this lesson has largely been forgotten or replaced with the innovation of new financial products believed to either maximize return or minimize risk within more liquid markets. Despite this, traditional equity and debt investments within this Real Asset maintain qualities that warrant their inclusion within contemporary investment portfolios and provide significant and distinct alternatives to financial assets.   

Real Estate up until several decades ago maintained a dominant position in most institutional portfolios. With the exception of the individual’s working within this very broad field, this fact is often forgotten with many individuals and institutions maintaining investments with lower barriers to entry regardless of the time horizon of their holding period. Real Estate has adjusted to this liquidity preference with widespread availability of Master Limited Partnerships, REITs, Closed End RE Mutual Funds and MBSs products Real Estate’s derivative products have become quite freely traded within liquid markets. However, this does come at a cost, often with characteristics and correlations that more closely confirm to equities and fixed income than their underlying asset. Characteristics that remain unique to direct equity and debt positions within Real Estate Properties and Projects include their potential to offer absolute returns, hedge against inflation, diversify the risk & return spectrum of traditional investments, provide cash flows as well as their potential to provide income tax advantages. Although contrasting investments may provide some of these benefits, these aggregated characteristics demand precise planning and expertise in order to maximize their return while minimizing downside portfolio risk.

Oppose to investments in stocks or mutual which often track their returns relative to an index or benchmark, ownership in private real estate ignores beta risk and offers investors and their portfolios the opportunity to track the performance of their investment in absolute returns. Absolute returns take into account an investments price appreciation, the depreciation of the asset and all subsequent cash inflows and outflows throughout the investments time horizon.

Real Estate provides hedges against inflation, which has remained below the Federal Reserves targeted rate of 2% since its establishment however, the point remains relevant in the event of forecasted inflation hikes as well as unexpected inflation hikes in the future. With inflation historically following non-linear patterns of growth, maintaining real assets with the ability to adjust to it’s corresponding increases provides a hedge its risk particularly in relation to traditional investments such as stocks and bonds which become discounted at greater inflation and interest rates.

Furthermore, real estate provides diversification with traditional investment with correlations across RE asset classes differing at times substantially from those of equity and bond indexes. The correlations are often increased substantially, if utilized with exchange traded derivatives or indexes, which capture liquidity preferences of investors operating within these markets. However, the underlying asset and its idiosyncratic features often offer a greater ability to mitigate systemic risk with traditional assets and derivatives of high liquidity.

Perhaps one of the most important characteristics of real estate investment is the tax benefits associated with its private ownership. Real Estate ownership in U.S. markets offers tax benefits for rental properties, apartments, and shopping centers, industrial, commercial and even vacant land through both depreciation as well as deductibility on debt interests. Subsequently, real estate sets itself apart from the direct ownership of stocks and bonds, which are subject to capital gains but fail to benefit from maintaining a depreciable basis.

Other Real Estate considerations, which make them somewhat unique within the investment landscape and often serve as a barrier to entry for many investors, is the heterogeneity, illiquidity and lumpiness of commercial and residential real estate. Unlike a broad index, such as the S&P or the Dow Jones, Real Estate is very property specific with diverse characteristics unique to each asset. Direct ownership in Real Estate ensures that owners maintain a high degree of unsystemic risk in addition to systemic risk. Furthermore, illiquidity may effect reported returns as well as create additional risk depending upon the investors exit strategy in the asset. Lastly, investors are acquiring lumpy assets in the sense they cannot easily be bought or sold in the exact quantities and sizes market participants prefer. Subsequently, diversification and portfolio balancing across this asset class is challenging in relation to exchange-traded alternatives.

The advantages and disadvantages associated with direct ownership in investable real estate are broad and significant. As a result, appropriately underwriting and managing these assets requires expertise within the asset as well as the specific market the property is located within. Despite the potential intricacies, Real Estate has historically and will remain an institutional quality investment with a enduring requirement to minimizing downside risk in order to maximize both project and portfolio return through active management and planning.