Prices and Appraisals: Where Is the Truth?

Article excerpt

"Shaky pension fund real estate portfolios likely will be slashed in value by 15% to 20% this year, the deepest cut ever...I personally believe there is going to be another round of write-downs in 1992. I don't think we are at the bottom yet in all property types and in all markets," said AT&T's Mr. Russo...Greenwich Associates' Mr. Smith believes, "a case can be made for a 20% spread between what real estate money managers are asking for their properties and what the private market is willing to pay" That spread is so wide, said Mr. Smith, "that real estate sales have virtually halted."(1)

An investor can buy a high-quality, unleveraged apartment house at the current market price and get an 8.5% first-year yield (NOI/price). The Russell-NCREIF annual income return is only 7.2% (first quarter 1992 annualized). Since income return provided by the index is a composite of property incomes divided by appraised values, are properties in the index on average overvalued? How accurate are the indexed properties' appraisals?

This article addresses this issue in four steps. It looks at the nature of real estate income return indices in terms of their intended benefits and the constraints associated with their construction. With this background, it examines the best available empirical evidence on the reliability of appraisal, labeling the result: the traditional appraisal lag. Using this foundation, it returns to the questions above and attempts to numerically reconcile index income yields with acquisition rates. Finally, the conclusions are reported.


What are the benefits of indices?(2) The reasons for having indices are no different today than they were at the turn of the century, when Irving Fisher wrote the highly acclaimed, (but not widely read) The Making of Index Numbers:

"To determine the pressure of steam, we do not take a popular vote: we consult a gauge. Concerning a patient's temperature, we do not ask for opinions: we read a thermometer. In economics, however, as in education, though the need for measurement is as great as in physics or in medicine, we have been guided in the past largely by opinions. In the future, we must substitute measurement. Toward this end, we must agree upon instruments of measurement...

The use of yardsticks of 40 different lengths would be a source of confusion: the use of 40 different kinds of index numbers is no less confusing. If experts fail to clear up this confusion because they disagree on non-essentials, it will seem to many people, to whom the mathematics of the subject is a mystery, as though the experts could not agree on fundamentals. And so, without due cause, index numbers in general will be discredited and the study of economics impeded. For this reason, it is to be hoped that all those who are capable of understanding the subject will agree in adopting and advocating for general use the Ideal Formula or a closely similar formula."(3)

Drawing from Fisher and our own experience with contemporary real estate investment management problems, we have prepared a list of reasons for a real estate index (Exhibit 1). As this exhibit clearly indicates a reliable real estate performance index is critical to the institutional real estate investment community.

The progression of improvements in stock market indices can provide a framework for understanding the first of the real estate performance indices, e.g., the Russell-NCREIF Property Index. We appreciate that no index is perfect. Investors continue to use the "Dow", even though it may be the most flawed of all stock market indices, because they understand it. Unless we develop a similar understanding of the Russell-NCREIF Property Index, we will not achieve the objectives listed in Exhibit I.



1. To study ex post performance (e.g., of an asset class) as a benchmark for asset allocation models. …


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