Real Estate Investments

Real Estate Indices

• Real estate (RE) indices are an increasingly
important aspect of RE investment management.
• The uses of these indices include the estimation of
risks and returns for assisting the asset allocation
decision making process, as well as the specification
of benchmarks for performance attribution.
• Using past data to infer the future risks and returns
of real estate is an important part of analysis,
portfolio allocation, and risk management.
 Real Estate Indices
• Main types of real estate indices available to market
participants:
– Appraisal- based
– Transaction-based
• Appraisal based indices are derived from the property
values estimated by appraisers, which may track a
particular sub-population.
• Transaction based indices are estimated based on
actual contemporaneous property sales of sample
properties that trade each period.
 Approaches to Appraisals
• Sales Comparison approach
– RE asset is evaluated against those of comparable properties that have
recently been sold. Value adjustment may be made for characteristics
such as square footage, date of sale, location etc.
• Cost Approach
– It assumes that a buyer will not pay more for a property than it would
cost to build an equivalent one.
• Income Approach
– Similar to DCF approach for valuing stocks/bonds. Several years of net
operating income is projected for a specific property or portfolio of
properties and then discounted using an appropriate discount rate.
This approach is particularly useful when valuing income-producing RE
assets, such as commercial real estate.
 Measurement of return
• The total return on an index is calculated as the sum of an
income return and a capital value return.
• The income portion of the total return of each property is a
fraction, with net operating income in the numerator and an
estimate of property value in the denominator.
• The numerator of the capital value return is the change in
the estimated value of the property from the beginning of a
period (say, a quarter) to the end of the period, adjusted for
capital improvements and partial sales such that increases
in the value due to further investments are not included as
profits. The denominator is the same as above .
 Transaction-based Indices
• The two main methods used are:
– Repeat sales method (RSM)
– Hedonic pricing method (HPM)
• A repeat sale occurs when a property is sold at
least two times during the sample period.
• RSM regresses the percentage price changes
observed in properties onto a sequence of
time-dummy variables.
 RSM- Example
• Assume two investors and two periods of time.
• Suppose that the first investor purchased his
property for $100,000 at the beginning of the
first period and sold it for $115,500 at the end
of the second period.
• Suppose the second investor purchased her
property at the beginning of of the second
period for $200,000 and sold at the end of that
period for $210,000.
 RSM: Set up the regression model
Dependent Variable Time Dummy Variables
Time period 1 Time period 2
115,500/100,000=1.155 1 1
210,000/200,000=1.05 0 1

The regression yields a 10% return as the coefficient of the first-period dummy
variable and 5% return as the coefficient of the second-period dummy variable
The Hedonic Pricing Method (HPM)
• The price of every real estate asset is determined
by the overall supply and demand conditions in
the local RE market, as well as by the different
set of attributes that the asset commands.
• HPM assumes that each of these attributes has
its own market, and the price of each attribute is
determined by its demand and supply.
• Examples of these attributes – number of rooms,
the size of the plot etc.
 Hedonic Price Index-three steps
• Model the value of RE properties as being a function
of specified characteristics of the properties.
• Use a sample of prices observed from recent
transactions to fit the parameters of the RE
valuation model, that is, determine the implicit price
of each attribute.
• Use the estimated valuation parameter to estimate
the values of the properties that are within the
index but did not transact.
 HPI- example
• Suppose value of office properties depends on
two variables- size and quality.

Given the above data, how to estimate the price of another Office G,
which is of quality type 2 and has 1,020 square feet?
 Investment Styles
• It refers to categorization of real estate
managers or real estate investments based on
risk and return expectations.
 Investment Styles
• The three styles divide real opportunities from
least risky (core) to most risky (opportunistic).
• Core properties tend to offer reliable cash flows
each year from rents and lease payments,
whereas opportunistic properties offer potential
capital appreciation and typically have little or
currently no reliable income.
• Core properties are somewhat bond-like in the
reliability of their income.
 Investment Styles
• Value-added real estate includes assets that exhibit one or
more of the following attributes:
– Achieving a substantial portion of their anticipated returns from
appreciation in value
– Exhibiting moderate volatility
– Not having the reliability of core properties
• The value-added RE styles includes hotels, resorts, assisted-care
living facilities, low-income housing etc.
• Value-added properties can also include new properties that
would otherwise be core properties except that they are not
fully leased, such as a new apartment complex or a new
shopping center.
 Investment Styles
• Opportunistic RE properties are expected to derive a
considerable part of their returns from property appreciation,
and may exhibit substantial volatility in value and returns.
• Opportunistic RE returns are more equity-like.
• Opportunistic RE is often accessed through RE opportunity
funds, sometimes called private equity real estate (PERE) funds,
which are simply private equity funds that invest in real estate.
• The majority of returns from opportunistic properties come
from value appreciation over a period of three-to-five years.
• Rollover risk is high.
 Rollover Risk
• RE rollover, in this context, refers to changes in
ownership, whereas real estate rollover more
generally refers to changes in financing (e.g.,
converting a construction loan to a permanent
mortgage loan).
• Since opportunistic properties are held for a
shorter term and for their potential to achieve
capital appreciation, the risk of failed or delayed
rollover is a substantial component of total risk.
 Purpose of RE style analysis
• There are three main reasons for introducing
styles into RE portfolio analysis:
– Performance measurement
– Monitoring style drift
– Style diversification
 Risk and Return with styles
• There are two major levels at which estimation of return
and risk involving RE should be performed by an asset
allocator:
– At the categories or styles level;
– At the individual fund, manager, or property level.
• In traditional investments such as equities, an analyst’s
expectations of risk and return are derived from historical
data.
• However, much of RE equity involves private RE, with little
or no direct and consistent observations of market prices.
 Core RE
• Expected return is based on past returns (cap rate).
• Cap rate =NOI/Value
– The ‘value’ is some measure of the RE’s total value, such
as purchased price or appraised value.
• Core RE Risk
– True Volatility= Smoothed Volatility X sqrt((1+rho)/(1-
rho)), where rho is the first order autocorrelation of the
smoothed series. It is assumed that the underlying true
series has no autocorrelation.
 Core Risk- Example
• Suppose the 25 years quarterly returns of a RE
index had a quarterly standard deviation of
2.4%. The first-order autocorrelation (rho) of
returns in 0.6. What is the true volatility?
• Systematic risk is estimated through beta.
– Beta(true series)=Beta (smoothed series)/(1-rho)
 Noncore RE Assets
• The expected risks and returns of value-added
and opportunistic RE investments are typically
estimated and expressed relative to the risks
and returns of core RE investments.
• The cap rate spread is the excess of the cap
rate over the yield of a default-free 10-year
bond
 Listed Vs. unlisted RE Investments
• Unlisted RE Funds
– Open-end RE funds: the redemption price is calculated
based on the quarterly appraisal value of the portfolio
of properties. Open-end RE funds are typically required
to fund redemptions out of the income received from
the underlying portfolio of properties.
– Closed-ended RE funds issue a general number of
shares to investors before any RE investments are
made.
– RE fund of funds
 Listed Vs. unlisted RE Investments
• Listed RE funds
– A real estate investment trust (REIT) is a
professionally managed investment vehicle that
invests in a portfolio of real estate assets, typically
with the goal of generating income (mainly rental
income) for its shareholders. REIT shares are
generally listed on stock exchanges.
– Exchange-traded funds based on real estate
indices
 REITs in India
• With REITs, investors can start with as small a
sum as Rs 2 lakhs, to secure units in exchange.
• The REIT platform has already been approved
by the Securities and Exchange Board of India
(SEBI) and like mutual funds, it will pool the
money from all investors across the country.
The money collected from the REIT funds, will
subsequently be invested in commercial
properties to generate income.
 REITs
• A REIT will need to be registered via an initial public
offering (IPO). REIT units will have to be listed with
exchanges and consequently, traded as securities.
• To begin with we see the REIT listings led by office
asset listings since this asset class constitutes the
largest portion of the yielding real estate available
in the country. Other real asset classes like shopping
centres/malls, hotels, industrial warehouses, etc.
also hold huge potential for REIT listings.
 Advantages with REITs*
• Income dividends: 90% of distributable cash, at least twice in a year.
• Transparency: REITs will showcase the full valuation on a yearly basis
and will also update it on a half-yearly basis.
• Diversification: According to the guidelines, REITs will have to invest in
a minimum of two projects with 60% asset value in a single project.
• Lower risk: At least 80% of the assets will have to be invested into
revenue-generating and completed projects. The remaining 20% include
under construction projects, equity shares of the listed properties,
mortgage-based securities, equity shares that derive a minimum of 75%
of income from government securities or G-secs, money market
instruments, cash equivalents and real estate activities.

• * Housing.com
 Mutual Funds in REITs
• A mutual fund can invest up to 5% of its net
asset value in units of a single issuer of 
REITs and InvITs, while the cap will not be
applicable in the case of index fund or sector
or industry-specific scheme. The overall limit
will be 10% of its NAV in units of REITs and
InvITs.