Does Private Real Estate Really Offer Diversification?
A criticism when discussing the risk-adjusted returns of direct real estate, as measured by appraisal based indexes such as the NCREIF NPI, is that volatility is understated because appraisal based valuations "smooth" volatility due to their backward looking nature.
Why the concern? Commercial properties are not transacted very often and as such appraisals are used to gauge the changes in the market value of a property. Appraisers use three methods to determine the value of real estate: 1) the income approach; 2) the sale comparable approach; 3) the cost of replacement approach. Often the final valuation is a weighted average of the three methods. Necessarily the appraiser is using past, not forward looking, data (e.g. comparable properties that have already sold, trailing twelve months income from the property, construction cost data from the recent cost indexes, etc.) as inputs to valuations. This could understandably generate an upward valuation bias when prices are trending lower and a downward bias when prices are trending higher.
The two methods primarily used to address the appraisal smoothing issue are: 1) applying an un-smoothing process and 2) constructing a transaction based index. Both methods, regardless of whether they increase stated volatilities of the unmodified appraisal based approach, continue to exhibit less volatility that both REIT and Stock indexes. [1]
I see two main issues that should be considered when thinking about this backward looking bias of appraisals. The first is the accuracy of the overall level of volatility of the asset class. The second is its correlations with other assets.
Firstly, the overall volatility. If an appraisal considers historic sales and not contemporaneous sales as of the date of the appraisal, the volatility of sale prices are still being captured, but simply at a lag. In other words, if every quarter an appraisal was performed that included sales from the previous quarter, the overall volatility in sales prices are captured but with a rolling 1 quarter delay. This doesn't minimize the overall volatility it just shifts its timing.
Secondly, the accuracy of correlations. If all returns comprising an appraisal based index were consistently lagged by the same amount of time, correlations might be misstated as you would be mismatching period returns with another asset's returns. Here it's important to understand that the whole issue with smoothing that we're discussing has to do with appreciation returns yet that's only one part of what makes up a commercial property's total return. The other part of the total return is the income return and this is not lagged. Nevertheless, lagging returns on the appraisal based NCREIF index for 1,2,3, and 4 quarters (meant to reflect that appraisal guidelines may allow for sale comps as far back as 1 year) still produce low correlations with the returns of the S&P 500 for the period from 1984-2015.
Conclusion
Lai & Wang (1998) found evidence that direct real estate investment volatility might actually be overstated in appraisal based valuation indices. [2] Despite this, the smoothing dynamic likely exists, yet it is largely a nit-picking exercise and does not impair the benefits of either risk-adjusted returns or strong diversification that direct real estate investment provides.
Also, to the degree that valuations are derived from the income approach, they should justifiably be less volatile. Most types of commercial real estate benefit from fairly stable, recurring rental revenue generated from contracts that generally carry a minimum period of 1 year. These revenues don't fluctuate with anything like the fickleness of publicly traded equity prices.
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1. (http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.979.1133&rep=rep1&type=pdf)
2. (https://www.researchgate.net/profile/Ko_Wang/publication/23523645_Appraisal_Smoothing_The_Other_Side_of_the_Story/links/00b7d51e6357dd846a000000.pdf)
