Real estate performance measures

Real Estate Issues, Dec 1995 by Fisher, Jeffrey D

The commercial real estate market is increasingly dominated by institutional investors who require periodic performance measures of their investment portfolios. This presents a challenge to private real estate investments because individual properties are not bought and sold on a regular basis like stocks and bonds. Therefore, investors cannot measure gains or losses in their real estate portfolio based on actual transaction prices. They must use alternative measures of real estate performance.

This article will provide an overview on how performance measures for real estate investments are constructed and used by institutional investors. In particular, the article will focus on an index of real estate performance published by the National Council of Real Estate Investment Fiduciaries (NCREIF). The index includes over 1,500 properties whose market value in 1995 exceeds $20 billion dollars of commercial real estate.(l) This article will show how the index is used both to gauge the performance of real estate compared to other asset classes and to measure the performance of different property types and geographic areas so institutional investors can make diversification decisions. Understanding these indices helps real estate professionals understand the motivations of institutional investors when purchasing, valuing and selling real estate income property. These indices can also be used to track trends in real estate values and capitalization rates for different property types and geographic areas.

Construction Of Performance Measures

Indices of real estate performance measure change in the rate of return over time, e.g., annual or quarterly rates of return. As indicated earlier, this is easy for publicly traded investments like stocks and bonds because transaction prices are available to measure changes in value. In the case of real estate, it is necessary to rely on appraised values as a proxy for transaction prices. Institutional investors which hold property for pension funds are required to mark to market, i.e., report the market value of their holdings. Thus, appraisals are done on a periodic basis, usually once per year by an outside appraiser with quarterly updates by inside appraisers.

Performance measures essentially calculate an internal rate of return (IRR) for each time period, e.g., each year, based on the appraised value of the property at the beginning and end of the period as well as the net operating income (NOI) received during the period. This is shown in the following equation:

Equation 1

Total Return = NOI (Sale price - Purchase price)/ Purchase Price (1)

Equation 1 calculates an internal rate of return for a single period of time. The return is called the total return because it includes return from net operating income and change in value (sale price -purchase price). This return assumes that the property could be sold each year at its appraised value.(2) In the case of stocks and bonds, dividend and interest income respectively would be used in place of NOI and actual transaction prices would be used for the sale price and purchase price.

Income And Capital Return

The total return already discussed can be broken down into an income return and a capital return. The income return is equal to

Income Return = NOI / Purchase Price (2)

The income return is analogous to an overall capitalization rate (cap rate) for a property. There may be differences, however, because the NOI used by the institutional investor may differ from the NOI used by an appraiser. For example, the institutional investor may not include any replacement allowance in the operating expenses which, compared to what the appraiser might estimate, may tend to understate the NOI. Alternatively, the institutional investor might include expenses for remodeling, leasing commissions, tenant improvements, etc. which, compared to what an appraiser would use as a stabilized expense, would overstate expenses.

Aside from these differences, trends in the income return can provide valuable insight into trends for capitalization rates. Thus, performance measures can provide a valuable complement to other sources of capitalization rates used by appraisers and counselors.

The capital return measures the effect of any appreciation or depreciation on the rate of return. It is calculated as follows: Capital Return = (Sale price - Purchase price) / Purchase Price (3)

The capital return assumes gain or loss which is recognized each period, e.g. the property is sold and repurchased. The capital return is also referred to as the appreciation return. It is possible, of course, that the appreciation be negative, i.e., depreciation in capital value.

Index

An index is often calculated from the return measures. The index indicates how much wealth the investor would have accumulated if he invested in the property and held it over time. It reflects cumulative rates of return over time. For example, if the total return was 5 percent in year 1 and 6 percent in year 2, n, an investment of $100 would increase to ($100 x 1.05 x 1.06) or $111.30 by the the end of the second year.