Real estate indices compare the performance of various asset types over time. The indices represent the population of real estate properties. For risk managers, often concerned with market value changes, the quarterly publication of the index may trigger buy or sell orders.
There are appraisal-based indices and transaction-based indices. Appraisal-based indices combine valuation information from individual properties and provide a measure of market movements. The NCREIF Property Index (NPI) measures the change in values of real estate. The quarterly return is a Holding Period Return (HPR) calculated as: NOI plus change in portfolio market value less capital expenditure, divided by beginning portfolio value.
Two relationships exist. First, HPR decreases if capital expenditure expense exceeds change in market value. Second, HPR decreases if the change in market value is negative. The relationship between HPR and NOI is not linear. A ten percent increase in NOI does not translate into a 10 percent increase in HPR.
Transaction-based indices use sale transactions rather than appraised values. Data analysis companies, such as Real Capital Analytics, collect information on actual transactions to create the index. Econometric techniques design the index. According to the index designers, the index methodology is a “state-of-the-art, academically published and vetted methodology that provides rigorous, objective and replicable information about the movement of commercial property prices over time.”
In practice, both indices offer a bird’s eye view of the performance of commercial real estate as an asset class. And it can be misleading. On one hand, the view from afar allows comparison of the performance of real estate versus other asset class performances, such as equities and bond markets. On the other hand, rapid changes in property value may be a catalyst. And with pricey transaction costs, the indices cost may outweigh their benefit.
Furthermore, appraisal-based indices often exhibit an appraisal lag and a smoothing effect. Appraisal lag occurs as conservative appraisal standards stray from rising housing prices, notes Jeff Brown, a columnist. The smoothing effect underestimates the fluctuation in the value of commercial real estate properties. In addition, because transaction-based indices rely heavily on statistical analysis, the published index value often includes error values or noise.