Q5. 1) What are primary causes of smoothing in commercial real estate indices?

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Q5. 1) What are primary causes of smoothing in commercial real estate indices? by Mind Map: Q5. 1) What are primary causes of smoothing in commercial real estate indices?

1. INDEX In general

1.1. 1. A major issue is the on-going debate around data smoothing and whether the valuation based indices understate the risk of property as an asset class

1.2. 2. The primary purpose of such indices is to provide a benchmark against which fund performance can be assessed

1.2.1. In more recent times they have also been used in derivative contracts


1.3.1. 3.The majority of commercial indices are based on valuations, due to the relative lack of transaction data –Also, the mix of the properties transacted in a specific period will change therefore lead to inconsistencies in the composition of the index –The only major transaction based index available is the NCREIF-TBI index in the US

2. The primary concern with commercial indices is that they provide smoothed return series

2.1. 4. Thereby: --Lagging true market values --Understating the true volatility of the asset

2.1.1. smoothing, defined as a temporal lag bias in valuation

3. As we'll see one of the key elements is knowing when you need to adjust for smoothing and when it is inappropriate to do so

3.1. 5. Autocorrelation

3.1.1. Property return indices display high degrees of autocorrelation

3.1.2. In addition, the magnitude of the autocorrelation tends to increase as the frequency of the index increases

3.1.3. The seasonal element introduced into the US NCREIF index through the failure to update all valuations each quarter can be seen by comparing the autocorrelation coefficients for the NCREIF and the Quarterly UK JLL Index Lag 1Lag 2Lag 3Lag 4UK (JLL)0.72650.53420.40000.3940USA (NCREIF)0.77300.70480.55050.5308

4. Valuation Methods & Cross-Autocorrelation

4.1. Unless one assumes that valuations always equal market value then it must be admitted that valuations are only point estimates and therefore may contain errors

4.1.1. --Accuracy of valuations versus prices --A smoothing element

4.1.2. If the valuation accuracy errors are randomly distributed across individual valuations then the index will be unbiased Therefore, the more important cause of index smoothing comes from elsewhere

4.2. Valuation Smoothing

4.2.1. Factors such as: --Incomplete market information --Professional guidelines requiring comparable evidence --Pressure by clients due to dislike of volatile movements in valuations May lead to valuer's being influenced by past information This may result in a contemporaneous valuation incorporating both lagged and contemporaneous market values, resulting in lagging & smoothing

4.3. Two papers appear to have found evidence to suggest the primary cause of index smoothing is not autocorrelation in individual property returns but cross-autocorrelation ¨CBrown & Matysiak (2000) ¨CTarbert & Marney (1998)

4.3.1. 6. Cross-Autocorrelation measures the lagging relationship between different assets This means that valuer’s don’t necessarily use information from previous valuations of the same property but evidence from similar properties

5. Temporal Aggregation

5.1. Temporal aggregation is where valuations undertaken at different times during the period in question are incorporated into the same index period

5.1.1. In the case of the NCREIF it is not even guaranteed that all properties are re-valued each quarter

5.1.2. This can result in the index reflecting not only changes in the current period but changes that occurred in previous periods as well

6. Index Aggregation

6.1. One factor that has received less attention is the issue of the aggregation that occurs when the index is constructed

6.1.1. Young & Greig (1993) argue that much of the smoothing induced into portfolios and indices results from the low correlation between individual property returns It is effectively derived from the heterogeneous nature of property Similar issues also arise when looking at similarly diverse assets such as hedge funds