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Compared to transaction-based indices used to track the performance of private real estate,
appraisal-based indices are most likely to exhibit an apparent:
A) time lag.
B) higher volatility.
C) higher correlation with other asset classes.
Kent Clarkson, Tony Chekov and Peter Chanwit are investment consultants for a large public
pension fund. They are partners in Clarkson, Chekov and Chanwit Consulting also known as
3CC. From previous meetings with the pension board, it has been established there will be
an increase in exposure to real estate for the overall portfolio. Because of the defined
benefit plan's significant size and their staff's expertise, the pension fund can invest and
manage all forms of real estate investments. Partners of 3CC are to recommend a form of
real estate investments, and recommend potential investments.
Expected Real Estate Market Conditions
Both residential and commercial real estate prices have fallen over the last five years. This
trend is not expected to persist. It is a 'buyer's market' – the current supply exceeds the
current demand and prices are lower than the intrinsic value. Although interest rates have
fallen to historically low rates, the volume of real estate transactions remains low. Current
average 20-year commercial mortgage rates are 3.75% and expected to stay relatively flat for
at least 7 more years.
Loan underwriting standards have become more stringent and loan-to-value (LTV) ratios are
expected to be lower than the earlier average rate of 80%.
The four forms of real estate under consideration as an investment choice for the pension
fund are:
Private: equity option is to buy commercial properties and manage them; debt option
is to directly lend to commercial property investors.
Public: equity option is to buy equity REITs; debt option is to buy mortgage REITs or
CMOs.
The following information was collected by 3CC partners to aid their analysis. The returns
and standard deviations of the four possible forms of real estate investments considered
are listed in Exhibit 1. Correlations of real estate index with Treasury bill returns, US
aggregate bond returns and US stock returns are listed in Exhibit 2.
Exhibit 1: Returns and Standard deviation (past 20 years)
Returns
σ
Private Equity
9.5%
6.5%
Private Debt
5.5%
8.5%
Public Equity
11.5%
21.0%
Public Debt
6.2%
22.5%
Treasuries
3.5%
0.6%
Exhibit 2: Correlation of Real Estate Index With Other Asset Classes (past 20 years)
Real Estate Index
Correlations
ρ
US Treasuries
0.35
US Aggregate Bonds
-0.05
US Stocks
0.25
The partners make the following statements:
Kent Clarkson: We should eliminate the private debt option from consideration. Returns for
private debt are likely to be low since interest rates are likely to remain low and the amount
of underwriting that is going to be required as a lender doesn't seem worth it.
Tony Chekov: I like the equity options better than the debt options based on Clarkson's
private debt expectations.
Peter Chanwit: I prefer the private option over the public option since the pension fund staff
can better actively manage the real estate projects and possibly outperform the index.
The partners have identified specific REIT managers who have consistently outperformed
their indices for the public option. They have also contacted potential high creditworthy
borrowers in case of private debt. For the private equity option, the partners are looking at
different commercial properties. They have narrowed their choices to hotels and multi-
family units.
Peter Chanwit is analyzing two specific buildings. Green Oaks Hotel and Blue Ridge
Apartments are next to each other; have exactly the same number of units, same amenities;
were built 10 years ago by the same construction company; and managed by the same
property management company. They are currently owned by different entities that are also
looking to provide the financing on the following basis.
Green Oaks Hotels
Blue Ridge Apartments
Asking Price
$25,000,000
Asking Price
$25,000,000
Annual NOI End of Year
1
$2,187,500
Annual NOI End of Year
1
$2,125,000
LTV
75.0%
LTV
70.0%
Loan Interest Rate
4.00%
Loan Interest Rate
3.50%
Monthly Debt Service
$113,621
Monthly Debt Service
$101,493
Loan Term
20 Years
Loan Term
20 Years
Expected Sales Price in
10 Yrs
$30,000,000.00
Expected Sales Price in
10 Yrs
$30,000,000.00
Principal Owed at End
of 10 Yrs
$11,222,397
Principal Owed at End of
10 Yrs
$11,144,755
The pension fund can buy one or both buildings provided they meet the minimum criteria of
a debt service coverage ratio of at least 1.50X and a levered IRR of at least 17.5%.
The indices under consideration as the benchmark for private real estate equity investing
are:
Jackson Property Index (JPI) is an appraisal based index.
Taft's Sales Index (TSI) is a repeat sales index.
Lincoln Hedonic Index (LHI) is a hedonic index.
Concerns regarding the index choice were verbalized at a 3CC meeting:
Kent Clarkson: I'm worried about Lincoln Hedonic Index. This index may adjust for
differences in property characteristics but I'm not sure it can be effective given that some
properties may not sell more than once during the index's coverage period.
Tony Chekov: I don't like the Jackson Property Index. Appraisals are estimates; there haven't
been many transactions lately so I question the reliability of the returns.
Peter Chanwit: I'm not sure about Taft's Sales Index. It relies on actual transactions but there
are so few sales recently so how reliable are the returns?