Real Estate Investment Indexes

Private equity real estate investment indexes allow investors to analyze property investment performance using either appraisal-based or transaction-based index methods.

To determine the best index method to employ, the investor needs to clearly understand the modalities of how the index was formulated and the underlying limitations to the varied index methods, which may result in a minimal correlation between the real estate investment and other asset groups.

Appraisal-based Indexes

This technique relies on real estate market performance appraisals to determine the change in property values over time. There are no sufficient transactions of comparable real estate property to indicate the value.

This method encompasses information on individual property appraisals to provide a measure of market performance.

The NCREIF Property Index originated from the United States and is predominantly used to quantify the variation in institutional investors’ real estate properties.

Information on NCREIF PI is gathered every quarter from investment managers and pension fund sponsors alongside information relating to NOI, capital expenditures, occupancy, etc. which in turn is processed to generate an index that calculates the holding period return of the properties every quarter as follows:

$$ \text{Return} = \frac { \left( \begin{align*} \text{NOI} & – \text{Capital expenditures} \\ & + ( \text{Ending market value}-\text{Beginning market value} ) \end{align*}\right) } {\text{Beginning market value}} $$

Note:

• The start and closing market values are obtained from the respective property appraisals.
• The holding period return is equal to a single-period IRR.
• The holding period return is calculated for each separate property, after which the resulting value is weighted to obtain the return for all properties in the index.
• Recall,

  $$ \text{cap rate} = \frac {\text{NOI}}{\text{Start market value}} = \text{Property income return} $$

Also,

$$ \text{Capital return} = \frac {\left( \begin{align*} & \text{Capital Expenditures} \\& + ( \text{Closing mkt value}-\text{Start mkt value} ) \end{align*} \right) }{\text{Start mkt value}} $$

The index allows the investors:

1. To create a comparison of performance against other asset groups.
2. The quarterly returns are then used to calculate risk (standard deviation).
3. The yardstick for returns against individual funds.

Potential biases against appraisal based indexes

• The appraisal-based index tends to delay actual transactions since actual transactions arise before appraisals are conducted, thereby ensuring that a change in price may not be included in appraised figures until the subsequent quarter.
• Delay in appraisal leads to reduce the volatility index.
• Delay in appraisal leads to a lower correlation with other asset groups, which can be resolved using the transaction-based index.

Transaction-Based Indexes

This takes into account companies that create an index based only on transactions and can be constructed using the following indexes:

• Repeat sales index– Focuses on recurring sales of the same property where a change in market situations can be computed once a real estate property is sold twice with the aid of a designed regression to assign the variation in values for each quarter. However, the index becomes more reliable as the sales increase.
• The hedonic index requires only a single sale of the same property, and regression is designed to regulate the differences in property attributes, e.g., size, age, location, etc.

Potential biases against transaction-based indexes

• It incorporates random fundamentals in the observations resulting from the use of statistical methods in estimating the index.
• These random elements result in fluctuations every quarter causing comparison lags.

Question

Which of the following statements about real estate indexes is most accurate?

1. Transaction-based indexes tend to delay the appraisal-based indexes.
2. Appraisal-based indexes tend to delay the transaction-based indexes.
3. Transaction-based indexes tend to have a lesser correlation with other asset classes in comparison to appraisal-based indexes.

Solution

The correct answer is B.

Appraisal-based indices tend to delay the transaction-based indices since real transactions occur before appraisals are conducted (appraisals are constructed from transaction data).

C is incorrect. Appraisal-based indices and not transaction-based indices seem to have lesser correlations with other asset classes.

A is incorrect. Appraisal-based indexes tend to delay actual transactions taking into account actual prices, which causes a delay in transaction-based indexes.

Reading 35: Overview of Types of Real Estate Investment

LOS 35 (e) Discuss real estate investment indexes, including their construction and potential biases.