Chapter 27: Real Estate Investment Management Part II: Performance Attribution & Evaluation.

Chapter 27:Chapter 27:Real Estate Investment Management Part II: Real Estate Investment Management Part II:

Performance Attribution & EvaluationPerformance Attribution & Evaluation

• What is meant by investment “performance attribution” at both the “macro-property level” and the portfolio level;

• How to quantify segment “allocation” versus asset “selection” effects in a portfolio’s differential performance relative to an appropriate benchmark;

• What is meant by formal, quantitative investment performance evaluation, and the role of this function in the relationship between investment managers and their investor clients;

• The nature of manager “custom benchmarking” in the private real estate asset class, and how this differs from corresponding practices in the public securities investment industry.

Chapter 27 Learning ObjectivesChapter 27 Learning Objectives

Chapter 27 Outline:

Introduction

27.1 Macro-level Investment Performance Attribution

27.1.1 Macro property level performance attribution

27.1.2 Portfolio level performance attribution

27.1.3 The use of a benchmark in performance attrib.

27.1.4 The case for using mgr alloc wts in the bnchmk

27.2 Investment Performance Evaluation & Benchmarking

27.2.1 The basic idea...

27.2.2 Benchmarks in the private R.E. asset class

27.2.3 Matching evaluation, responsibility, & auth.

27.2.4 The problem of statistical significance

27.2.5 Implications of the lack of stat. significance

27.2.6 Adjusting for risk

27.3 Conclusions

Macro-Level Investment Policy Analysis:Macro-Level Investment Policy Analysis:

• StrategicStrategic Investment Decision Making: Investment Decision Making:- Long-run objectives & plan:Long-run objectives & plan:

- Chapter 21 (Portf Theory) Chapter 21 (Portf Theory) Basic methodologyBasic methodology..

- Chapter 22 (Equilibr Models) Chapter 22 (Equilibr Models) Rational expectations to apply Rational expectations to apply MPT.MPT.

• TacticalTactical Investment Policy: Investment Policy:- Short/medium term actions (opportunistic):Short/medium term actions (opportunistic):

- Chapter 22 (Equilibr Models) Chapter 22 (Equilibr Models) Find mis-priced assets.Find mis-priced assets.

• Policy Policy ImplementationImplementation::- Investment management:Investment management:

- Chapters 26 & 27 (Perf. Attrib., Benchmarking).Chapters 26 & 27 (Perf. Attrib., Benchmarking).

- Chapter 22 (Equilibr Models) Chapter 22 (Equilibr Models) Risk-adjustment for perf. Attrib.Risk-adjustment for perf. Attrib.

- Most relevent for private direct investment Most relevent for private direct investment

- Also relevant for REIT mgt to consider, as REITs can be viewed as Also relevant for REIT mgt to consider, as REITs can be viewed as mgrs of direct priv R.E. investments on behalf of stockholders.mgrs of direct priv R.E. investments on behalf of stockholders.

DEFINITIONDEFINITION: : The formal (quantitative) The formal (quantitative) comparisoncomparison of a given of a given investment agent’s (or portfolio’s) investment investment agent’s (or portfolio’s) investment performance with that of a suitably defined index or peer performance with that of a suitably defined index or peer group, over a specified time period.group, over a specified time period.

EXAMPLEEXAMPLE::• A large-cap stock manager is “benchmarked against the A large-cap stock manager is “benchmarked against the S&P500”…S&P500”…• Manager averages a 10% return over a 3-yr mgt Manager averages a 10% return over a 3-yr mgt contract period…contract period…• S&P500 averages 12% over the same period…S&P500 averages 12% over the same period…• Manager has some “Manager has some “explainingexplaining” to do.” to do.

What isWhat is““BenchmarkingBenchmarking”” ? ?

DEFINITIONDEFINITION: : The The decompositiondecomposition of the total investment performance of the total investment performance into additive componentsinto additive components so as to “attribute” the total so as to “attribute” the total performance to sources that may reflect various performance to sources that may reflect various investment management investment management functionsfunctions. .

EXAMPLEEXAMPLE::• Manager 10% vs NCREIF 12%, but…Manager 10% vs NCREIF 12%, but…• If mgr had allocated among different property types in If mgr had allocated among different property types in same proportion as NCREIF Index, then mgr would have same proportion as NCREIF Index, then mgr would have earned 13%:earned 13%: Mgr relative good at individual asset Mgr relative good at individual asset “selection”“selection”;; Source of poor relative performance must be Source of poor relative performance must be “allocation”“allocation” across property type market segments. across property type market segments.

What isWhat is““Performance AttributionPerformance Attribution”” ? ?

Some historical Perspective…Some historical Perspective…

• MPT (1950s & 60s)MPT (1950s & 60s)

• CAPM (1960s & 70s)CAPM (1960s & 70s)Invstmt Mgt Perf.Eval: Invstmt Mgt Perf.Eval: “Risk-adjusted returns”“Risk-adjusted returns”::

““Jensen’s Alpha”, “Sharpe Ratio”, “Treynor Ratio”.Jensen’s Alpha”, “Sharpe Ratio”, “Treynor Ratio”.

• Disillusionment with CAPM (1980s & 90s):Disillusionment with CAPM (1980s & 90s):Going beyond “beta” to explain expected returns: Going beyond “beta” to explain expected returns: Size, Size, B/M Ratio,…B/M Ratio,…

• “ “StyleStyle” oriented invstmt strategy (1980s & 90s):” oriented invstmt strategy (1980s & 90s):Style-based benchmarking as an invstmt mgt tool, Style-based benchmarking as an invstmt mgt tool, consistent with style-based portfolio strategy.consistent with style-based portfolio strategy.

• Property “Crash” of early 1990s:Property “Crash” of early 1990s:Benchmarking expands from equities to R.E. (1990s).Benchmarking expands from equities to R.E. (1990s).

• 27.1. Performance Attribution27.1. Performance Attribution

• 27.2. Basics of Benchmarking27.2. Basics of Benchmarking

• 27.2 (cont.). Issues in Benchmarking 27.2 (cont.). Issues in Benchmarking Private Real EstatePrivate Real Estate

Lecture Outline:Lecture Outline:

27.1. Performance Attribution27.1. Performance Attribution

• Definition & Overview.Definition & Overview.

• 27.1.2. Portfolio-Level Performance Attribution.27.1.2. Portfolio-Level Performance Attribution.

• 27.1.1 Property-Level Performance Attribution.27.1.1 Property-Level Performance Attribution.

DEFINITION: DEFINITION: The The decompositiondecomposition (or “breaking down”, or “parsing”) of (or “breaking down”, or “parsing”) of the total investment return of a subject property or the total investment return of a subject property or portfolio of properties (or an investment manager).portfolio of properties (or an investment manager).

PURPOSE:PURPOSE:To assist with the To assist with the diagnosisdiagnosis and understanding of what and understanding of what caused the given investment performance.caused the given investment performance.

USAGE:USAGE:By investment managers (agents) and their clients By investment managers (agents) and their clients (principals).(principals).REIT managers also could use.REIT managers also could use.

Performance Attribution Overview . . .Performance Attribution Overview . . .

• Portfolio levelPortfolio levelPertains to dynamic portfolios or investment manager Pertains to dynamic portfolios or investment manager

(or fund) level.(or fund) level.

• Property levelProperty levelPertains to individual properties or static portfolios of Pertains to individual properties or static portfolios of multiple properties.multiple properties.


Two levelsTwo levels at which performance attribution is performed:at which performance attribution is performed:

Major Major attributesattributes (return components): (return components):

At the PORTFOLIO LEVEL:At the PORTFOLIO LEVEL:AllocationAllocationSelectionSelection

InteractionInteraction

At the PROPERTY LEVEL:At the PROPERTY LEVEL:Initial Cash YieldInitial Cash Yield

Cash Flow ChangeCash Flow ChangeYield ChangeYield Change


Portf Tot.Return – Bnchmk Tot.ReturnPortf Tot.Return – Bnchmk Tot.Return

AllocationAllocation SelectionSelection InteractionInteraction

Portfolio Level:Portfolio Level:

Prop.IRR – Bnchmk Cohort IRRProp.IRR – Bnchmk Cohort IRR

Init.YieldInit.Yield CF GrowthCF Growth Yield ChgeYield Chge

Property Level:Property Level:


• At both levels, At both levels, diagnosticdiagnostic purpose is facilitated by purpose is facilitated by comparison between comparison between subjectsubject portfolio or mgr with an portfolio or mgr with an appropriateappropriate benchmarkbenchmark..

• Relative Relative (or (or differentialdifferential) performance betw subj vs ) performance betw subj vs benchmrk is quantified, in total & w/in components.benchmrk is quantified, in total & w/in components.

Alloc Strategy Alloc Strategy Across SegmentsAcross Segments

Asset Picking & Asset Picking & Oper.MgtOper.Mgt

Alloc & Selection Alloc & Selection SynergySynergy

AllocationAllocation SelectionSelection InteractionInteraction

For example, at the For example, at the portfolioportfolio level… level…


Basic idea is that components of the performance Basic idea is that components of the performance differential between the subject & the benchmark reflect differential between the subject & the benchmark reflect performance of various distinct performance of various distinct functionsfunctions of investment of investment management.management.

Note: In private R.E., the asset “Note: In private R.E., the asset “SelectionSelection” ” function also includes asset function also includes asset Operational Operational Management.Management.

Init.YieldInit.Yield CF ChangeCF Change Yield ChgeYield Chge

AcquisitionAcquisition

SelectionSelection

OperationalOperational

MgtMgt

Mgt & DispMgt & Disp

SelectionSelection


For example, at the For example, at the propertyproperty level… level…

Basic idea is that components of the performance Basic idea is that components of the performance differential between the subject & the benchmark reflect differential between the subject & the benchmark reflect performance of various distinct performance of various distinct functionsfunctions of investment of investment management.management.

A basic problem with all performance A basic problem with all performance attribution analyses:attribution analyses:

It is generally impossible to define unique, It is generally impossible to define unique, unambiguous break-downs or components of the unambiguous break-downs or components of the total return that correspond to clear causal total return that correspond to clear causal determinants or investment management determinants or investment management functions.functions.

Nevertheless,Nevertheless,

Some useful insights can be obtained from Some useful insights can be obtained from performance attribution, provided results are performance attribution, provided results are

used carefully.used carefully.


• Performance attribution lacks significance for any one Performance attribution lacks significance for any one short holding period (e.g., quarter or year).short holding period (e.g., quarter or year).

• When aggregating across periods:When aggregating across periods:

• At the At the portfolio levelportfolio level (i.e., for (i.e., for allocationallocation and and selectionselection attribution), it is generally best to use the attribution), it is generally best to use the arithmetic TWRRarithmetic TWRR of the attribution components (for of the attribution components (for component additivity).component additivity).

• At the At the property levelproperty level (i.e., for (i.e., for initial yieldinitial yield, , cash flow cash flow changechange, and , and yield changeyield change attribution), it is probably attribution), it is probably more appropriate to use the more appropriate to use the IRRIRR, because capital , because capital flow timing is controlled by the property flow timing is controlled by the property (investment) manager at the property level.(investment) manager at the property level.


Multi-period AttributionMulti-period Attribution

Simple Numerical Example:Simple Numerical Example:• Bob & Sue are competing property investment managers Bob & Sue are competing property investment managers specializing in office and industrial property.specializing in office and industrial property.• Over the same time period they made the following segment Over the same time period they made the following segment allocations and achieved the following returns…allocations and achieved the following returns…

Exhibit 27-2: Bob & Sue's returns realized for clients:

Weights: Bob: Sue:

Industr 90% 10%

Office 10% 90%

Returns: Bob: Sue:

Total Portfolio 9.20% 9.70%

Industrial Properties 9.00% 7.00%

Office Properties 11.00% 10.00%

•Sue beat Bob by 50 basis points, 9.70% to 9.20%, in total portfolio Sue beat Bob by 50 basis points, 9.70% to 9.20%, in total portfolio performance, which is what counts.performance, which is what counts.• But how can we But how can we attributeattribute this total performance differential between this total performance differential between the two major functions an investment manager performs @ portf the two major functions an investment manager performs @ portf level: segment level: segment allocationallocation, and asset , and asset selectionselection?…?…

27.1.2 Portfolio-Level27.1.2 Portfolio-Level Performance Attribution . . . Performance Attribution . . .

Suppose (to simplify the illustration) that Bob’s performance is Suppose (to simplify the illustration) that Bob’s performance is identical to whatever benchmark index would be an appropriate identical to whatever benchmark index would be an appropriate reference for Sue’s performance. Then we can attribute Sue’s reference for Sue’s performance. Then we can attribute Sue’s differential performance, with respect to her benchmark, to allocation differential performance, with respect to her benchmark, to allocation ((AASS–A–A

BB) and selection (S) and selection (SSS–S–S

BB)) as follows: as follows:

SSSS–S–SBB = w= w

BIBI(r(rSISI – r – r

BIBI) + w) + wBOBO(r(r

SOSO – r – rBOBO))

= 0.9(7%-9%) + 0.1(10%-11%) = 0.9(7%-9%) + 0.1(10%-11%)

= -1.8% - 0.1% = -1.9%= -1.8% - 0.1% = -1.9%

27.1.3. Use of a Benchmark in Performance Attribution . . .27.1.3. Use of a Benchmark in Performance Attribution . . .

The most logical way to perform this type of comparative attribution The most logical way to perform this type of comparative attribution analysis is to define a common analysis is to define a common benchmarkbenchmark that is an appropriate that is an appropriate reference point for both Bob’s and Sue’s performance.reference point for both Bob’s and Sue’s performance.

AASS–A–ABB = r= r

BIBI(w(wSISI – w – w

BIBI) + r) + rBOBO(w(w

SOSO – w – wBOBO))

= 9%(0.1-0.9) + 11%(0.9-0.1) = 9%(0.1-0.9) + 11%(0.9-0.1)

= -7.2% + 8.8% = +1.6%= -7.2% + 8.8% = +1.6%

Sue's returns vs her benchmark:

Weights: Benchmark Sue:

Industr 90% 10%

Office 10% 90%

Returns: Benchmark: Sue:




Clearly, Sue outperformed her benchmark (9.70% vs Clearly, Sue outperformed her benchmark (9.70% vs 9.20%, a +50 bp differential) because of her superior 9.20%, a +50 bp differential) because of her superior allocation (90% to the office segment that did better than allocation (90% to the office segment that did better than industrial property), not because of her selection (which industrial property), not because of her selection (which actually hurt her performance, as her properties did worse actually hurt her performance, as her properties did worse than the benchmarks within each segment).than the benchmarks within each segment).

The The purepure effect of her differential performance in the effect of her differential performance in the selection and allocation functions is quantified as follows…selection and allocation functions is quantified as follows…

Portfolio-Level Performance Attribution . . .Portfolio-Level Performance Attribution . . .

The pure effect of Sue’s allocation choices, relative to The pure effect of Sue’s allocation choices, relative to her benchmark, is quantified as the sum across all her benchmark, is quantified as the sum across all segments, of the difference between Sue’s allocation segments, of the difference between Sue’s allocation and the benchmark’s allocation multiplied by the and the benchmark’s allocation multiplied by the benchmark’sbenchmark’s return in each segment. return in each segment.






The pure effect of Sue’s asset selection, relative to her The pure effect of Sue’s asset selection, relative to her benchmark, is quantified as the sum across all segments benchmark, is quantified as the sum across all segments of the difference between Sue’s within-segment return of the difference between Sue’s within-segment return and the benchmark’s within-segment return, weighted by and the benchmark’s within-segment return, weighted by the the benchmark’sbenchmark’s allocation to each segment. allocation to each segment.





Thus, the pure effect of Sue’s selection performance relative Thus, the pure effect of Sue’s selection performance relative to her benchmark was:to her benchmark was:





= 0.9(7%-9%) + 0.1(10%-11%) = 0.9(7%-9%) + 0.1(10%-11%)

= -1.8% - 0.1% = -1.9%= -1.8% - 0.1% = -1.9%

She lost 1.9% relative to her benchmark because her She lost 1.9% relative to her benchmark because her industrial properties did 2% worse than the benchmark’s industrial properties did 2% worse than the benchmark’s industrial properties and her office properties did 1% worse industrial properties and her office properties did 1% worse than the benchmark’s office properties, and her benchmark than the benchmark’s office properties, and her benchmark allocation was 90% to industrial.allocation was 90% to industrial.

Note that in order to avoid mixing the effect of Sue’s Note that in order to avoid mixing the effect of Sue’s allocation in with the effect of her selection, we quantify her allocation in with the effect of her selection, we quantify her selection effect using the selection effect using the benchmark’sbenchmark’s allocation. allocation.


Similarly, the pure effect of Sue’s allocation performance Similarly, the pure effect of Sue’s allocation performance relative to her benchmark was:relative to her benchmark was:





= 9%(0.1-0.9) + 11%(0.9-0.1) = 9%(0.1-0.9) + 11%(0.9-0.1)

= -7.2% + 8.8% = +1.6%= -7.2% + 8.8% = +1.6%

She gained 1.6% relative to her benchmark because she put She gained 1.6% relative to her benchmark because she put 80% more weight than her benchmark into office 80% more weight than her benchmark into office properties, and office properties performed 2% better than properties, and office properties performed 2% better than industrial properties within the benchmark.industrial properties within the benchmark.

Note that in order to avoid mixing the effect of Sue’s Note that in order to avoid mixing the effect of Sue’s selection performance in with the effect of her allocation, selection performance in with the effect of her allocation, we quantify her allocation effect using the we quantify her allocation effect using the benchmark’sbenchmark’s selection performance.selection performance.


The sum of these two pure effects of Sue’s selection and allocation The sum of these two pure effects of Sue’s selection and allocation performance does not equal her total return performance differential performance does not equal her total return performance differential with respect to her benchmark.with respect to her benchmark.

The remaining performance differential is due to the The remaining performance differential is due to the combined effectcombined effect of Sue’s selection and allocation performances of Sue’s selection and allocation performances interactinginteracting together. together. (There is no meaningful way to disentangle this interaction effect and (There is no meaningful way to disentangle this interaction effect and allocate it to either one of the two pure effects.)allocate it to either one of the two pure effects.)

Sue vs her benchmark:

Attribute:

Allocation 1.60%

Selection -1.90%

Interaction 0.80%

Total differential 0.50%


Sue's returns vs her benchmark:

Weights: Benchmark Sue:

Industr 90% 10%

Office 10% 90%

Returns: Benchmark: Sue:




Sue vs her benchmark:

Attribute:

Allocation 1.60%

Selection -1.90%

Interaction 0.80%

Total differential 0.50%

The interaction effect is sometimes called the “cross-product”. The interaction effect is sometimes called the “cross-product”.

Some analysts suggest that it reflects the investment manager’s Some analysts suggest that it reflects the investment manager’s “specialization” ability, her degree of success in over-weighting segments in “specialization” ability, her degree of success in over-weighting segments in which the manager has relatively better (or less bad) selection skills even which the manager has relatively better (or less bad) selection skills even though her overall selection ability may be weak and such segments may though her overall selection ability may be weak and such segments may not be strategically superior from an overall allocation perspective. not be strategically superior from an overall allocation perspective.

e.g., Sue over-weighted office, where her selection was “less bad” than in e.g., Sue over-weighted office, where her selection was “less bad” than in industrial, so she achieved a positive interaction (specialization) effect.industrial, so she achieved a positive interaction (specialization) effect.


Some analysts use the manager’s weights to compute the “selection” effect:Some analysts use the manager’s weights to compute the “selection” effect:


SISI(r(rSISI – r – r

BIBI) + w) + wSOSO(r(r


= 0.1(7%-9%) + 0.9(10%-11%) = 0.1(7%-9%) + 0.9(10%-11%)

= -0.2% - 0.9% = -1.1%= -0.2% - 0.9% = -1.1%

This allocates the entire performance differential to just selection and This allocates the entire performance differential to just selection and allocation, eliminating the interaction effect:allocation, eliminating the interaction effect:

Alloc (Sue – Bnchmrk) = Alloc (Sue – Bnchmrk) = +1.6%+1.6%+ Select(Sue-Bnchmrk) = + Select(Sue-Bnchmrk) = - 1.1%- 1.1%

--------------Total Total +0.5%+0.5%

27.1.4. Mgr Allocation Weights in the Benchmark?...27.1.4. Mgr Allocation Weights in the Benchmark?...

But it is misleading to define the selection effect this way and think of it as a But it is misleading to define the selection effect this way and think of it as a pure selection effect. It would be more meaningful to explicitly combine the pure selection effect. It would be more meaningful to explicitly combine the interaction effect with selection and call it “Selection&Allocation”.interaction effect with selection and call it “Selection&Allocation”.

The The meaningmeaning of portfolio-level attribution in private of portfolio-level attribution in private real estate investment (as distinct from public securities real estate investment (as distinct from public securities investment)…investment)…

• The The allocationallocation component has a very similar meaning in private component has a very similar meaning in private real estate as compared to public securities (corresponding to the real estate as compared to public securities (corresponding to the segment weight allocation decision at the portfolio level), but…segment weight allocation decision at the portfolio level), but…

• The The selectionselection component in private real estate encompasses both component in private real estate encompasses both the traditional “asset picking” function of securities investment the traditional “asset picking” function of securities investment management (picking good individual assets), and also (unlike management (picking good individual assets), and also (unlike with public securities) the with public securities) the acquisition acquisition andand operational management operational management function associated with negotiating private asset deals and long-function associated with negotiating private asset deals and long-term holding of a real property asset that must be managed by its term holding of a real property asset that must be managed by its investor/owner. (i.e., purely “investor/owner. (i.e., purely “passivepassive” investment is not possible in ” investment is not possible in the private real estate investment industry.)the private real estate investment industry.)


It is very difficult to break down the overall It is very difficult to break down the overall selectionselection performance between the contributions provided by performance between the contributions provided by the “traditional selection” (asset picking) function and the “traditional selection” (asset picking) function and that provided by the that provided by the acquisitionacquisition and and operational operational managementmanagement functions. functions.

Some insight may be obtained by analysis of Some insight may be obtained by analysis of property-property-levellevel performance attribution. In particular:performance attribution. In particular:

• Initial yieldInitial yield relates to the relates to the traditional selectiontraditional selection & & acquisitionacquisition functions;functions;

• Cash flow changeCash flow change relates largely to the relates largely to the operational operational managementmanagement function (but not purely or necessarily, e.g., it function (but not purely or necessarily, e.g., it may reflect expiration of vintage leases);may reflect expiration of vintage leases);

• Yield changeYield change may reflect either a may reflect either a traditional selectiontraditional selection (asset (asset picking) effect or an picking) effect or an operational managementoperational management effect, or both. effect, or both.


27.1.1 Property-Level27.1.1 Property-Level Performance Attribution . . . Performance Attribution . . .

Property level performance attribution focuses on “Property level performance attribution focuses on “property property levellevel” investment performance, i.e., the total return achieved ” investment performance, i.e., the total return achieved within a given property or a static (fixed) portfolio of within a given property or a static (fixed) portfolio of properties (that is, apart from the effect of investment properties (that is, apart from the effect of investment allocation decisions, as if holding allocation among categories allocation decisions, as if holding allocation among categories constant).constant).

Property level attribution should be designed to break out Property level attribution should be designed to break out the property level total return performance in a manner the property level total return performance in a manner useful for shedding light on the four major property level useful for shedding light on the four major property level investment management functions:investment management functions:• Property selectionProperty selection (picking “good” properties as found); (picking “good” properties as found);• Acquisition transaction executionAcquisition transaction execution;;• Operational managementOperational management during the holding period (e.g., during the holding period (e.g., marketing, leasing, expense mgt, capital expenditure mgt);marketing, leasing, expense mgt, capital expenditure mgt);• Disposition transaction executionDisposition transaction execution..

PropertyProperty-Level Performance Attribution . . .-Level Performance Attribution . . .

These property-level management functions are related These property-level management functions are related generally to three attributes (components) of the property-generally to three attributes (components) of the property-level level since-acquisition IRRsince-acquisition IRR, essentially as indicated below…, essentially as indicated below…

Initial Yield

(IY)

Cash Flow Change

(CFC)

Yield Change

(YC)

Property Selection

Acquisition Transaction Execution

Operational Management

Disposition Transaction Execution

Conventional property level performance attribution is Conventional property level performance attribution is based on periodic returns, or on time-weighted multi-period based on periodic returns, or on time-weighted multi-period returns (TWRRs).returns (TWRRs).

But But IRRIRR-based performance attribution is arguably more -based performance attribution is arguably more useful for property level management diagnostic purposes, useful for property level management diagnostic purposes, because:because:

• At the property level, the investment manager is typically At the property level, the investment manager is typically responsible for the major cash flow responsible for the major cash flow timingtiming decisions that can decisions that can significantly effect property level (static portfolio) returns, e.g., significantly effect property level (static portfolio) returns, e.g., leasing decisions, capital expenditure decisions.leasing decisions, capital expenditure decisions.

• The IRR is sensitive to the effect of cash flow timing, the TWRR is The IRR is sensitive to the effect of cash flow timing, the TWRR is not.not.

• The The IRR is cash flow basedIRR is cash flow based (net of capital improvement (net of capital improvement expenditures), therefore, more accurately reflecting the investment expenditures), therefore, more accurately reflecting the investment return effect of capital improvement decisions.return effect of capital improvement decisions.


Useful IRR-Based property level performance attribution Useful IRR-Based property level performance attribution benchmarking requires the use of:benchmarking requires the use of:

Since-acquisition IRRSince-acquisition IRR

• IRR is computed IRR is computed since acquisitionsince acquisition of property (or portfolio): of property (or portfolio):

• In order to reflect investment operational performance In order to reflect investment operational performance during entire holding period since acquisition;during entire holding period since acquisition;

• Property investment holding periods are typically multi-Property investment holding periods are typically multi-year (single period or periodic returns do not reflect effective year (single period or periodic returns do not reflect effective investment management holding period).investment management holding period).

• IRR is computed for appropriate IRR is computed for appropriate benchmark cohortbenchmark cohort, , defined as universe of similar investments by competing defined as universe of similar investments by competing managers, measured from same inception date (equal to managers, measured from same inception date (equal to property acquisition date).property acquisition date).


Simple Numerical Example:Simple Numerical Example:

• Property (or static portfolio) bought at initial cash Property (or static portfolio) bought at initial cash yield of 9%.yield of 9%.

• Net cash flow grew at 2% per year.Net cash flow grew at 2% per year.

• Property (or properties) sold (or appraised) after 10 Property (or properties) sold (or appraised) after 10 years at a terminal yield of 10%, based on yr.11 years at a terminal yield of 10%, based on yr.11 projected cash flow (also 2% more than yr.10).projected cash flow (also 2% more than yr.10).

• IRR is 10.30%.IRR is 10.30%.

• How much of this IRR is due to 3 components: How much of this IRR is due to 3 components: Initial Yield (Initial Yield (IYIY), Cash Flow Change (), Cash Flow Change (CFCCFC), and ), and Yield Change (Yield Change (YCYC)?…)?…

Recall Ch.10 Appendix: Recall Ch.10 Appendix: PropertyProperty-Level Performance Attribution . . .-Level Performance Attribution . . .

Yr IRRs: 0 1 2 3 4 5 6 7 8 9 10 11

(1) Actual Oper.CF 1.0000 1.0200 1.0404 1.0612 1.0824 1.1041 1.1262 1.1487 1.1717 1.1951 1.2190(2) Actual Capital CF -11.1111 12.1899(3) Actual Total CF (=1+2) 10.30% -11.1111 1.0000 1.0200 1.0404 1.0612 1.0824 1.1041 1.1262 1.1487 1.1717 13.3850(4) Init.Oper.CF constant 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000(5) Capital CF @ Init.Yld.on(4) -11.1111 11.1111(6) Init.CF @ Init.Yld (=4+5) 9.00% -11.1111 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 12.1111(7) Capital CF @ Init.Yld.on(1) -11.1111 13.5444(8) Actual Oper. CF @ Init.Yld (=1+7) 11.00% -11.1111 1.0000 1.0200 1.0404 1.0612 1.0824 1.1041 1.1262 1.1487 1.1717 14.7395(9) Capital CF @ ActualYld.on(4) -11.1111 10.0000(10) Init.CF @ Actual Yld (=4+9) 8.32% -11.1111 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 11.0000

There are several ways one might answer this question. The approach that There are several ways one might answer this question. The approach that seems most intuitively related to the 4 basic mgt fcns is presented here…seems most intuitively related to the 4 basic mgt fcns is presented here…

• Initial yield = 9.00%,Initial yield = 9.00%, computed from line (6) IRR. computed from line (6) IRR.• Cash flow change component = 2.00%Cash flow change component = 2.00% = 11%-9%, computed as the line (8) IRR = 11%-9%, computed as the line (8) IRR less the line (6) IRR: = IRR with actual CF – IRR with no CF growth, (with constant less the line (6) IRR: = IRR with actual CF – IRR with no CF growth, (with constant yld at initial rate).yld at initial rate).• Yield change component = -0.68%Yield change component = -0.68% = 8.32%-9.00%, computed as the line (10) IRR = 8.32%-9.00%, computed as the line (10) IRR less the line (6) IRR: = IRR with actual yld chg – IRR with no yld chg, (with constant less the line (6) IRR: = IRR with actual yld chg – IRR with no yld chg, (with constant CF at initial level).CF at initial level).• Interraction effect = -0.02%Interraction effect = -0.02%, the difference bertween the line (3) overall IRR and , the difference bertween the line (3) overall IRR and the sum of the three other attributes [10.3%-(9%+2%-0.68%)].the sum of the three other attributes [10.3%-(9%+2%-0.68%)].

Property-Level Performance Attribution . . .Property-Level Performance Attribution . . .

Subject Property: IRR & Component Breakout

-4%-2%0%2%4%6%8%

10%12%14%

IRR InitYld CFchg YldChg Interaction

IRR & Components

Here is a graphical presentation of the IRR-Based property-level Here is a graphical presentation of the IRR-Based property-level performance attribution we just performed:performance attribution we just performed:

Suppose we computed the same type of IRR component breakdown Suppose we computed the same type of IRR component breakdown for an appropriate benchmark, that is, a NCREIF sub-index cohort for an appropriate benchmark, that is, a NCREIF sub-index cohort spanning the same period of time…spanning the same period of time…

Property-Level Performance Attribution . . .Property-Level Performance Attribution . . .We could compare our subject performance with that achieved by a We could compare our subject performance with that achieved by a peer universe of managers, for similar properties (e.g., Calif. Industr. peer universe of managers, for similar properties (e.g., Calif. Industr. bldgs):bldgs):

Subject vs NCREIF Cohort Performance Comparison: IRR & Component Breakout

-5%

0%

5%

10%

15%


IRR & Components

Subject NPI Cohort

Property-Level Performance Attribution . . .Property-Level Performance Attribution . . .Here is the Here is the relative performancerelative performance, the , the differencedifference between our subject between our subject property and its benchmark, by attribute:property and its benchmark, by attribute:

The above pattern could be plausibly interpreted as tentative evidence for The above pattern could be plausibly interpreted as tentative evidence for the following hypothesis: Subject performed relatively poorly due largely to the following hypothesis: Subject performed relatively poorly due largely to some combination of poor selection, acquisition, and operational mgt, some combination of poor selection, acquisition, and operational mgt, partially offset by some combination of good disposition execution (or partially offset by some combination of good disposition execution (or optimistic terminal appraisal), future-oriented capital improvements, &/or optimistic terminal appraisal), future-oriented capital improvements, &/or market movements during the holding period.market movements during the holding period.

Subject - NCREIF Cohort Relative Performance: IRR & Component Breakout

-2.50%

-2.00%

-1.50%

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%


IRR & Components


These property-level management functions are related These property-level management functions are related generally to three attributes (components) of the property-generally to three attributes (components) of the property-level level since-acquisition IRRsince-acquisition IRR, essentially as indicated below…, essentially as indicated below…

Initial Yield

(IY)

Cash Flow Change

(CFC)

Yield Change

(YC)

Property Selection

Acquisition Transaction Execution

Operational Management

Disposition Transaction Execution

Property-Level Performance Attribution . . .Property-Level Performance Attribution . . .Here is the Here is the relative performancerelative performance, the , the differencedifference between our subject between our subject property and its benchmark, by attribute:property and its benchmark, by attribute:

Now suppose we computed these relative performance differentials across a Now suppose we computed these relative performance differentials across a number of different properties (or portfolios) we have invested in…number of different properties (or portfolios) we have invested in…

Subject - NCREIF Cohort Relative Performance: IRR & Component Breakout

-2.50%

-2.00%

-1.50%

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%


IRR & Components

Property-Level Performance Attribution . . .Property-Level Performance Attribution . . .We might gain some insights about our property-level investment and We might gain some insights about our property-level investment and management performance:management performance:

In this case Subject Properties #1 & 3 have similarly poor performance (rel to In this case Subject Properties #1 & 3 have similarly poor performance (rel to benchmk), due to poor initial yield & poor CF change, suggesting poor acquisition & benchmk), due to poor initial yield & poor CF change, suggesting poor acquisition & poor operational mgt. Property #2 did better, with good InitYld & CFchg, but poor poor operational mgt. Property #2 did better, with good InitYld & CFchg, but poor YldChg (suggesting good acquisition, but poor disposition or mgt actions that hurt YldChg (suggesting good acquisition, but poor disposition or mgt actions that hurt future outlook (e.g., inadequate Cap.Improvement). Mkt movements can also affect future outlook (e.g., inadequate Cap.Improvement). Mkt movements can also affect these results (less so the longer the holding period).these results (less so the longer the holding period).

Three Properties Comparison:Subject - NCREIF Cohort Relative Performance

-5.00%

-4.00%

-3.00%

-2.00%

-1.00%

0.00%

1.00%

2.00%

3.00%


Subject 1 Subject 2 Subject 3

27.2 Investment Performance 27.2 Investment Performance Evaluation & BenchmarkingEvaluation & Benchmarking

• How Benchmarking Is DoneHow Benchmarking Is Done

• Purpose & Role of BenchmarkingPurpose & Role of Benchmarking

• Criteria of an Ideal BenchmarkCriteria of an Ideal Benchmark

How Benchmarking Is Done in the Securities Industry. . .How Benchmarking Is Done in the Securities Industry. . .

3-year

Time-Wtd

Return

Investment Mgt “Style” or Asset Class

Style A

Compute ex post Compute ex post total TWRR of all total TWRR of all competing competing managers in an managers in an active mgr “active mgr “peer peer universeuniverse” (same ” (same “style”), over a “style”), over a common historical common historical period (indicated by period (indicated by this this rangerange).).


3-year

Time-Wtd

Return


Style A

Compute inter-Compute inter-quartile range of quartile range of the peer universethe peer universe


3-year

Time-Wtd

Return


Style A

Compute median Compute median TWRR of the peer TWRR of the peer universeuniverse


3-year

Time-Wtd

Return


Style A

Index AIndex A

Compute TWRR of Compute TWRR of a a passive indexpassive index representative of representative of style.style.


3-year

Time-Wtd

Return


Style A

Index AIndex A

Mgr AMgr A

Compute TWRR of Compute TWRR of the subject active the subject active manager or manager or actively-managed actively-managed portfolio.portfolio.


3-year

Time-Wtd

Return


Style A

Index AIndex A

Mgr AMgr ACompare subj mgr’s Compare subj mgr’s performance to that of:performance to that of:

• The passive indexThe passive index

• The peer universeThe peer universe


3-year

Time-Wtd

Return


Style A

Index AIndex A

Mgr AMgr A

Style B

Mgr BMgr B

Index BIndex B

Do the same Do the same withinwithin each style each style


The Importance of Style-Purity in the Benchmark:The Importance of Style-Purity in the Benchmark:

• Not appropriate to compare performance of one style of Not appropriate to compare performance of one style of investment against that of another for evaluating a investment against that of another for evaluating a manager who is specialized in (and hired for the purpose manager who is specialized in (and hired for the purpose of) investing in one particular style. of) investing in one particular style.

• Multi-style managers and portfolios can be benchmarked Multi-style managers and portfolios can be benchmarked using composite indices constructed from an appropriate using composite indices constructed from an appropriate combination of style-pure indices. combination of style-pure indices.

• Comparative analysis and diagnostics regarding the Comparative analysis and diagnostics regarding the differential performance of different types (styles) of differential performance of different types (styles) of investments is facilitated by the availability of style-pure investments is facilitated by the availability of style-pure indices.indices.

1.1. Communication (Client Communication (Client Manager). Manager).

2.2. Interest-Alignment (Client Interest-Alignment (Client Manager). Manager).

3.3. Weed out Weed out inferiorinferior managers. managers.

The Purpose of Benchmarking . . .The Purpose of Benchmarking . . .

Ex AnteEx Ante Purposes (most important): Purposes (most important):

Ex Post Ex Post Purpose (less important or less feasible):Purpose (less important or less feasible):

4. Identify 4. Identify superiorsuperior managers (in combination managers (in combination with qualitative information).with qualitative information).


Ex Post Ex Post Purpose (less important or less feasible):Purpose (less important or less feasible):

4. Identify 4. Identify superiorsuperior managers (in combination managers (in combination with qualitative information).with qualitative information).

Why is the identification of superior managers Why is the identification of superior managers difficult in practice?difficult in practice?

• “ “Superior mgr” = One who can Superior mgr” = One who can consistentlyconsistently beat mkt. beat mkt.

• “ “Superior mgr” = One who can Superior mgr” = One who can consistentlyconsistently beat peers. beat peers.

• This is This is rarerare, and normally only , and normally only marginalmarginal..

• Moving targetMoving target: Mkt (& peer universe) learns & improves : Mkt (& peer universe) learns & improves over time.over time.


Why is the identification of superior Why is the identification of superior managers difficult in practice?managers difficult in practice?

• “ “Superior mgr” = One who can Superior mgr” = One who can consistentlyconsistently beat mkt. beat mkt.

• “ “Superior mgr” = One who can Superior mgr” = One who can consistentlyconsistently beat peers. beat peers.

• This is This is rarerare, and normally only , and normally only marginalmarginal..

• Moving targetMoving target: Mkt (& peer universe) learns & improves : Mkt (& peer universe) learns & improves over time.over time.

• But there is also a But there is also a statistical reason . . .statistical reason . . .

27.2.4: 27.2.4: The Problem ofThe Problem of Statistical SignificanceStatistical Significance in Performance in Performance Measurement . . .Measurement . . .

• “ “Noise” (or Noise” (or randomnessrandomness) in ex post returns obscures ) in ex post returns obscures our ability to draw rigorous conclusions about our ability to draw rigorous conclusions about managers’ abilities to managers’ abilities to consistentlyconsistently beat a benchmark as beat a benchmark as a result of a result of skillskill (& effort) rather than (& effort) rather than luckluck..

• There are three sources of randomness in empirically There are three sources of randomness in empirically observable real estate returns:observable real estate returns:

1.1. Cross-sectionalCross-sectional (individ. prop. heterogeneity). (individ. prop. heterogeneity).

2.2. LongitudinalLongitudinal randomness in true mkt (volatility). randomness in true mkt (volatility).

3.3. Measurement errorMeasurement error (in R.E. returns). (in R.E. returns).

• Any (& all) of these sources of “noise” obscures the Any (& all) of these sources of “noise” obscures the “signal” about mgrs’ true relative abilities.“signal” about mgrs’ true relative abilities.

Numerical Example:Numerical Example:

• Quarterly returns, Quarterly returns, 3-yr3-yr comparison period. comparison period.

• 12 obs12 obs drawn from drawn from true true difference between mgr(i) & difference between mgr(i) & benchmark(B) return: benchmark(B) return: EE[ [ rri i – r– rB B ].].

• Suppose favorable circumstances for making inference:Suppose favorable circumstances for making inference:• EE[ [ rri i – r– rB B ] constant] constant over time. over time.• VolatilityVolatility of of rrii & & rrBB = = 5%/qtr5%/qtr (each). (each).• CORRCORR [ [ rri i , r, rB B ] = ] = +90%.+90%.

• Then mgr TWRR would have to beat benchmark by Then mgr TWRR would have to beat benchmark by >500 >500 basis-pointsbasis-points per annum before we could conclude with per annum before we could conclude with statistical significance that the central tendency of the mgr’s statistical significance that the central tendency of the mgr’s return exceeds that of the benchmark return (i.e., rigorous return exceeds that of the benchmark return (i.e., rigorous case for case for skillskill as opposed to as opposed to luckluck).).



Calculations:Calculations:• Standard error of quarterly difference in returns:Standard error of quarterly difference in returns:

%24.2

)05.0)(05.0)(9.0(205.005.0

2

21

22

21

22

BiBiBi C

• Standard error of observed qtrly avg difference =Standard error of observed qtrly avg difference =

%675.0112%24.21 21

NBi

• X 2 std.errs for 95% statistical confidence: 2(0.675%) = X 2 std.errs for 95% statistical confidence: 2(0.675%) = 1.35%.1.35%.

• Annualize: (1.0135)Annualize: (1.0135)44 – 1 = – 1 = 5.51%5.51% /yr. difference required. /yr. difference required.


Implications:Implications:

• You cannot use purely quantitative benchmarking You cannot use purely quantitative benchmarking comparisons to rigorously identify superior managers ex comparisons to rigorously identify superior managers ex post.post.

• Don’t apply such benchmarking Don’t apply such benchmarking mechanisticallymechanistically or in or in isolation.isolation.

• Include broader analyses and qualitative information in Include broader analyses and qualitative information in conjunction with quantitative benchmarking:conjunction with quantitative benchmarking:

• Performance attribution analysis may be useful in this Performance attribution analysis may be useful in this regard.regard.

• And remember . . .And remember . . .


Implications:Implications:

Ex AnteEx Ante Purposes (most important): Purposes (most important):

• Communication (Client Communication (Client Manager). Manager).

• Interest-Alignment (Client Interest-Alignment (Client Manager). Manager).

• Weed out Weed out inferiorinferior managers. managers.

• The The ex anteex ante role of benchmarking is not negated by the role of benchmarking is not negated by the problem of lack of statistical significance:problem of lack of statistical significance:

• Even with noise, a better mgr who works harder for the client is Even with noise, a better mgr who works harder for the client is more likely to beat the benchmark.more likely to beat the benchmark.• Communication betw mgr & client is improved by identification of Communication betw mgr & client is improved by identification of benchmark at outset of contract.benchmark at outset of contract.

27.2.2. Criteria for an 27.2.2. Criteria for an Ideal Benchmark IndexIdeal Benchmark Index . . . . . .

3-year

Time-Wtd

Return


Style A

Mgr AMgr A

Index AIndex A

Recall that two different Recall that two different types of benchmarks are types of benchmarks are often used in the often used in the securities industry:securities industry:

• Passive mkt indicesPassive mkt indices, &, &

• Peer universesPeer universes..

Which of these is better Which of these is better as a benchmark?as a benchmark?


In the securities industry, there is some argument that peer In the securities industry, there is some argument that peer universes are not as good as passive market indices for universes are not as good as passive market indices for benchmarking purposes:benchmarking purposes:

• Peer universes suffer from “survivor bias”.Peer universes suffer from “survivor bias”.

• Peer universes don’t meet all of the “Peer universes don’t meet all of the “Bailey CriteriaBailey Criteria”:”:

The “Bailey Criteria”:

• Unambiguous

• Investable

• Measurable

• Specified in advance

• Appropriate to Mgr

• Reflective of Mgr


Alas, in private real estate, we don’t really have a Alas, in private real estate, we don’t really have a passive passive market indexmarket index, that is, an index that:, that is, an index that:

• Covers the entire commercial property market; &Covers the entire commercial property market; &

• Maintains a constant set of assets.Maintains a constant set of assets.

Private real estate benchmark indices are Private real estate benchmark indices are peer universe peer universe indicesindices::

• Indices that represent the performance of (almost) the Indices that represent the performance of (almost) the entire populationentire population of properties held by the universe of of properties held by the universe of investment managers competing for the business of the investment managers competing for the business of the institutional “institutional “corecore” style of private real estate investment.” style of private real estate investment.

• ““Active”Active” mgt is mgt is necessarynecessary in private R.E. investment in private R.E. investment (operational control of assets).(operational control of assets).

• The NCREIF Index is a peer universe index in the US.The NCREIF Index is a peer universe index in the US.

• The IPD Index is a peer universe index in the UK.The IPD Index is a peer universe index in the UK.


How serious a problem is the lack of a passive market index How serious a problem is the lack of a passive market index for the private real estate investment industry? . . .for the private real estate investment industry? . . .

• Such an index would be very useful for Such an index would be very useful for researchresearch purposes. purposes.

• But, in contrast to the securities industry, the argument for But, in contrast to the securities industry, the argument for the superiority of passive market indices for the superiority of passive market indices for benchmarkingbenchmarking purposes purposes does not carry over to the private real estate does not carry over to the private real estate investment industryinvestment industry::

• There is not much of a survivorship problem in property-level There is not much of a survivorship problem in property-level indices such as NCREIF.indices such as NCREIF.• Investment turnover is not rapid in R.E. indices.Investment turnover is not rapid in R.E. indices.• Some of the “Bailey Criteria” do not make sense for the private Some of the “Bailey Criteria” do not make sense for the private real estate investment industry.real estate investment industry.

e.g., perfect index investability is not possible in an asset class where e.g., perfect index investability is not possible in an asset class where unique, whole assets are traded.unique, whole assets are traded.


Fundamental Criteria of Benchmark Indices:Fundamental Criteria of Benchmark Indices:

1.1. Measurability: Measurability: QUANTITATIVE COMPARISON.QUANTITATIVE COMPARISON.

2. Client 2. Client Investability: Investability:

MGR HIRED FOR MGR HIRED FOR INCREMENTALINCREMENTAL CONTRIBUTION CONTRIBUTION OVER WHAT CLIENT COULD DO.OVER WHAT CLIENT COULD DO.

3. Manager No Forced Bet: 3. Manager No Forced Bet: MGT PRINCIPLE: MGT PRINCIPLE: EVALUATION = RESPONSIBILITY = AUTHORITY.EVALUATION = RESPONSIBILITY = AUTHORITY.

4. Appropriateness (Mgr Style & Spec.): 4. Appropriateness (Mgr Style & Spec.): USEFULNESS FOR USEFULNESS FOR CLIENT STRATEGY IMPLEMENTATION, FAIRNESS FOR MGR.CLIENT STRATEGY IMPLEMENTATION, FAIRNESS FOR MGR.

5. Non-manipulatability:5. Non-manipulatability: CREDIBILITY & CREDIBILITY & EX ANTEEX ANTE ROLE. ROLE.

6. Agreement in Advance: 6. Agreement in Advance: COMMUNICATION & FAIRNESS.COMMUNICATION & FAIRNESS.


Peer universe indices (like the NCREIF Index) implement Peer universe indices (like the NCREIF Index) implement these criteria reasonably well for the private real estate these criteria reasonably well for the private real estate investment industry. E.g.,:investment industry. E.g.,:

Client Investability:Client Investability: Client could have hired any other competing Client could have hired any other competing mgr from peer universe, instead of subj.mgr., mgr from peer universe, instead of subj.mgr., so peer universe is “so peer universe is “ex ante investableex ante investable”.”.

Manager No Forced Bet:Manager No Forced Bet: Mgr can duplicate Mgr can duplicate typestypes of properties in of properties in peer universe index.peer universe index.

•Peer universe benchmark indices are like a Peer universe benchmark indices are like a ““Consumer ReportsConsumer Reports”” of of the investment industry.the investment industry.•You compare a given investment manager’s performance with that You compare a given investment manager’s performance with that of all of his relevant competitors (“peers” – managers the investor of all of his relevant competitors (“peers” – managers the investor could have hired instead of the given manager: i.e., those with the could have hired instead of the given manager: i.e., those with the same style & specialization).same style & specialization).

Peer universe indices are Peer universe indices are reasonablereasonable and and prudentprudent measures for measures for benchmarking private real estate performance.benchmarking private real estate performance.


Some practical implications of ideal benchmark Some practical implications of ideal benchmark criteria:criteria:

CRITERIA:CRITERIA:3. Manager No Forced Bet3. Manager No Forced Bet

&&4. Appropriateness4. Appropriateness

• Fixed real return targets Fixed real return targets are are NOTNOT good Benchmarks. good Benchmarks.

• Direct (private) real estate Direct (private) real estate investment mgrs or investment mgrs or portfolios should portfolios should NOTNOT be be benchmarked against REIT benchmarked against REIT Indices.Indices.

27.2 (cont.):27.2 (cont.):

Issues in Benchmarking Private Real EstateIssues in Benchmarking Private Real Estate

• Population vs sample implications.Population vs sample implications.

• Controlling for risk.Controlling for risk.

• Segment weighting in the benchmark index.Segment weighting in the benchmark index.

• Valuation methodology.Valuation methodology.

• IRR vs TWRR benchmarking.IRR vs TWRR benchmarking.

27.2.2 (cont.): Population vs Sample Implications . . .27.2.2 (cont.): Population vs Sample Implications . . .

Is the ideal benchmark index an entire Is the ideal benchmark index an entire populationpopulation, , or is it a or is it a samplesample??

What is the difference?, and why does it matter?What is the difference?, and why does it matter?

Census of entire population Census of entire population No need for statistical No need for statistical inference.inference.

Sampling Sampling Can’t avoid statistical inference issues. Can’t avoid statistical inference issues.

Ideal Ideal benchmarkbenchmark index = Entire peer universe index = Entire peer universe populationpopulation::• Practical feasibility to include entire peer universe (almost).Practical feasibility to include entire peer universe (almost).• Legalistic function, Avoid “error” in comparisons.Legalistic function, Avoid “error” in comparisons.

Ideal asset class Ideal asset class researchresearch index = Scientific index = Scientific samplesample::• Asset class too large, Census impractical.Asset class too large, Census impractical.• But peer universe is not a “But peer universe is not a “scientificscientific” sample.” sample.

Implications for appropriate index construction Implications for appropriate index construction methodology…methodology…

N

itit r

Nr

1,

1

Index as Sample Index as Sample Equal-weighted returns (EW): Equal-weighted returns (EW):

Index as Population Index as Population Value-weighted returns (VW): Value-weighted returns (VW):

N

iti

t

tit r

V

Vr

1,

1

1,

27.2.2 (cont.): Population vs Sample Implications . . .27.2.2 (cont.): Population vs Sample Implications . . .

The Problem:The Problem:

• The Capital Market naturally provides higher returns The Capital Market naturally provides higher returns (on avg over LR) for “more risky” assets.(on avg over LR) for “more risky” assets.

• Manager must not be able outperform benchmark Manager must not be able outperform benchmark simplysimply by investing in more risky assets or using by investing in more risky assets or using leverage.leverage.

• Hence, we need to Hence, we need to CONTROL FOR RISKCONTROL FOR RISK..

27.2.6. Controlling for Risk . . .27.2.6. Controlling for Risk . . .

Two ways to control for risk:Two ways to control for risk:

• QuantitativelyQuantitatively, using “, using “risk-adjusted returnsrisk-adjusted returns”, by ”, by adjusting the mgr’s ex post return to reflect the adjusting the mgr’s ex post return to reflect the market’s “price of risk”.market’s “price of risk”.

• Non-quantitativelyNon-quantitatively, using “, using “style-based benchmarkingstyle-based benchmarking”, ”, by constraining manager to same style (similar-risk) by constraining manager to same style (similar-risk) assets, same style & risk as his benchmark.assets, same style & risk as his benchmark.


i

fii

rrTR

BetaBeta = Amount of “Risk” = Amount of “Risk” AS IT AS IT MATTERS TO THE CAPITAL MARKETMATTERS TO THE CAPITAL MARKET..

This enables Portfolio “i”’s ex ante excess This enables Portfolio “i”’s ex ante excess return, E[return, E[rrii-r-rff], to be ], to be ADJUSTED FOR ADJUSTED FOR

RISKRISK..


The The Quantitative Quantitative Approach: e.g., The Approach: e.g., The Treynor RatioTreynor Ratio......

The The Quantitative Quantitative Approach: e.g., The Approach: e.g., The Treynor RatioTreynor Ratio......

Avg. Excess Return

Beta

SML

11

rM - rf

0

ri - rf

TRTRii

ββii



Within the private real estate investment industry, we must Within the private real estate investment industry, we must rely primarily on the “Non-Quantitative” (Style-Based) rely primarily on the “Non-Quantitative” (Style-Based) Approach to controlling for risk. Approach to controlling for risk. Why?Why?


Within the private real estate investment industry, we must Within the private real estate investment industry, we must rely primarily on the “Non-Quantitative” (Style-Based) rely primarily on the “Non-Quantitative” (Style-Based) Approach to controlling for risk. Approach to controlling for risk.

• We cannot effectively quantify risk in the private We cannot effectively quantify risk in the private real estate asset class real estate asset class in the way that it matters to the in the way that it matters to the capital marketcapital market, so we cannot quantify , so we cannot quantify risk-adjusted risk-adjusted return measuresreturn measures with sufficient credibility for use in with sufficient credibility for use in benchmarking.benchmarking.

• The property market cannot distinguish between the The property market cannot distinguish between the amount of risk in different types or locations of amount of risk in different types or locations of properties (so long as they are all “institutional-properties (so long as they are all “institutional-quality”).quality”).

NCREIF Division/Type Portfolios: Returns vs NWP Factor Risk

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

-0.5 0.0 0.5 1.0 1.5

Beta w rt NWP=(1/3)St+(1/3)Bn+(1/3)RE

Avg

Exc

ess

Ret

urn

(ovr

T-b

ills)


Horiz. Axis is Beta wrt “National Wealth Portf”, but that doesn’t matter.

Within the private real estate investment industry, we must Within the private real estate investment industry, we must rely primarily on the “Non-Quantitative” (Style-Based) rely primarily on the “Non-Quantitative” (Style-Based) Approach to controlling for risk. Approach to controlling for risk. Recall Ch.22 (sect.22.3)…Recall Ch.22 (sect.22.3)…

At this level of detail, At this level of detail, WITHIN A WITHIN A GIVEN STYLEGIVEN STYLE ofof the (instl) R.E. the (instl) R.E. asset class, the market cannot asset class, the market cannot distinguish stable, reliable distinguish stable, reliable differences at the property level in differences at the property level in ““betabeta”, the risk that matters.”, the risk that matters.


Therefore, we not only Therefore, we not only cannotcannot, but we , but we need notneed not adjust for risk, as long as the manager & his adjust for risk, as long as the manager & his benchmark are both confined benchmark are both confined WITHIN A GIVEN WITHIN A GIVEN STYLESTYLE of the institutional RE asset class. of the institutional RE asset class.

Within the private real estate investment industry, we must Within the private real estate investment industry, we must rely primarily on the “Non-Quantitative” (Style-Based) rely primarily on the “Non-Quantitative” (Style-Based) Approach to controlling for risk. Approach to controlling for risk.

Real Estate “Styles” are a bit vaguely defined:Real Estate “Styles” are a bit vaguely defined:• Domestic “Core”Domestic “Core”

• Value-added/OpportunisticValue-added/Opportunistic

• InternationalInternational

• etc (NCREIF currently working on etc (NCREIF currently working on standardized style definitions).standardized style definitions).


Discrete style/risk categories defined by:Discrete style/risk categories defined by:• Property size limits;Property size limits;• Leverage limits;Leverage limits;• Development project exposure limits (occupancy).Development project exposure limits (occupancy).

In practice, this approach requires considerable In practice, this approach requires considerable specification & elaboration betw agent & principal at outset specification & elaboration betw agent & principal at outset of mgt contract, & perhaps on-going. of mgt contract, & perhaps on-going.

27.2.6. Controlling for Risk . . .27.2.6. Controlling for Risk . . .Example:Example:• Fund restricted to fully-stabilized core property Fund restricted to fully-stabilized core property

investments, but investments, but allows use of high leverageallows use of high leverage (up to 75%, (up to 75%, at discretion of fund mgr).at discretion of fund mgr).

• Appropriate benchmark & risk control could be either:Appropriate benchmark & risk control could be either:1.1. Peer universe of all (& only) other such funds, orPeer universe of all (& only) other such funds, or2.2. NCREIF Index adjusted for leverage using a WACC NCREIF Index adjusted for leverage using a WACC

formula, with a pre-specified target leverage ratio:formula, with a pre-specified target leverage ratio:

rrEE == r rDD + (+ (rrPP – – rrDD))LRLRWhere: Where: rrEE == Levered equity return,Levered equity return,

rrDD == Debt return,Debt return,

rrPP == Property (unlevered) return (NPI),Property (unlevered) return (NPI),

LRLR = = Leverage ratio (Leverage ratio (V/EV/E), pre-specified.), pre-specified.

27.2.6. Controlling for Risk . . .27.2.6. Controlling for Risk . . .Some implications of style-based benchmarking:Some implications of style-based benchmarking:

• Fixed real return targets are not good benchmarks.Fixed real return targets are not good benchmarks.

• Direct property investment should not generally be Direct property investment should not generally be benchmarked against a REIT Index, benchmarked against a REIT Index, howeverhowever::

• Property operational level performance Property operational level performance comparisons & attribution analyses may be of interest comparisons & attribution analyses may be of interest for diagnostic purposes at the property-level across for diagnostic purposes at the property-level across all properties of a given type, including different types all properties of a given type, including different types (or styles) of investor/owners.(or styles) of investor/owners.

• Comparisons Comparisons acrossacross styles or peer groups are of styles or peer groups are of interest at a broader level, relevant for strategic interest at a broader level, relevant for strategic investment and asset class investment and asset class researchresearch (as opposed to (as opposed to agent performance evaluation benchmarking, per se).agent performance evaluation benchmarking, per se).

The previous conclusion about inability to use quantitative The previous conclusion about inability to use quantitative (risk-adjusted return-based) control for risk does not (risk-adjusted return-based) control for risk does not necessarily hold for portfolios (or mgrs) that span necessarily hold for portfolios (or mgrs) that span ACROSSACROSS multiple asset class quadrants. .multiple asset class quadrants. . . .

• REITsREITs

• CMBSCMBS

• Whole LoansWhole Loans

• Private R.E. EquityPrivate R.E. Equity

• etc. . .etc. . .

Controlling for Risk at a Broader Level (Ch.22, Sect.22.2). . .Controlling for Risk at a Broader Level (Ch.22, Sect.22.2). . .

Look at this plot of average returns and betas Look at this plot of average returns and betas ACROSSACROSS multiple quadrants. . .multiple quadrants. . .

Ex Post CAPM on Mkt=(1/3)RE+(1/3)Bonds+(1/3)Stocks

0.0%

1.0%

2.0%

3.0%

0 0.5 1 1.5 2 2.5

Beta* RE betas = sum of 8qtrs lagged coeffs

Avg

Exc

ess

Ret

urn

(per

qtr

, ove

r Tb

ills)

NCREIF

LTBond

SP500

HOUSCMORT

REIT

SMALST


Regression statistics for historical returns Regression statistics for historical returns ACROSSACROSS multiple quadrants. . .multiple quadrants. . .


0.0%

1.0%

2.0%

3.0%

0 0.5 1 1.5 2 2.5


Avg

Exc

ess

Ret

urn

(per

qtr

, ove

r Tb

ills)

NCREIF

LTBond

SP500

HOUSCMORT

REIT

SMALST

•Adj. R2 = 73%

• Intercept is Insignif.

•Coeff on Beta is Pos & Signif.


““BetaBeta” wrt “” wrt “National WealthNational Wealth” is priced ” is priced ACROSSACROSS the the quadrants quadrants . . .. . .


0.0%

1.0%

2.0%

3.0%

0 0.5 1 1.5 2 2.5


Avg

Exc

ess

Ret

urn

(per

qtr

, ove

r Tb

ills)

NCREIF

LTBond

SP500

HOUSCMORT

REIT

SMALST

•Adj. R2 = 73%

• Intercept is Insignif.

•Coeff on Beta is Pos & Signif.

““CAPM works...”CAPM works...”


The Capital Market does perceive (and price) risk differences The Capital Market does perceive (and price) risk differences ACROSSACROSS quadrants. . . quadrants. . .

National Wealth BETABETA

Pub.EqPub.Eq

Pub.DbPub.Db

Pri.DbPri.Db

Pri.EqPri.Eq

E[r]


Asset Class Ex Post Betas and Risk Premia (Per Asset Class Ex Post Betas and Risk Premia (Per Annum, over T-bills, 1981-98)...Annum, over T-bills, 1981-98)...

Asset Class:Excess

Return: Beta:Small Stocks 8.48% 1.94

S&P500 10.48% 1.72

REITs 4.32% 1.22

LT Bonds 6.24% 1.07

Com.Mortgs 4.15% 0.66

NCREIF 1.15% 0.34

Houses 3.59% 0.23


The The Treynor Ratio Treynor Ratio (or something like it) should be applied to (or something like it) should be applied to multi-quadrant managers (portfolios)...multi-quadrant managers (portfolios)...

Avg. Excess Return

Beta

SML

11

rM - rf

0

ri - rf

TRTRii

ββii


The The Beta Beta can be estimated based on the can be estimated based on the ““National Wealth PortfolioNational Wealth Portfolio”” (( = = (1/3)Stocks + (1/3)Bonds + (1/3)RE (1/3)Stocks + (1/3)Bonds + (1/3)RE ) as the multi-quadrant “Risk Benchmark”) as the multi-quadrant “Risk Benchmark”..

Avg. Excess Return

Beta

SML

11

rM - rf

0

ri - rf

TRTRii

ββii

Based on “National Wealth Portfolio”“National Wealth Portfolio”


27.2.3. Segment weighting in the benchmark index. . .27.2.3. Segment weighting in the benchmark index. . .

Definition:Definition:Real estate asset market “Real estate asset market “segmentsegment””

= Property type & geographic location.= Property type & geographic location.

• Suppose manager has discretion to allocate capital Suppose manager has discretion to allocate capital across more than one segment.across more than one segment.

• Then benchmark should include all the segments Then benchmark should include all the segments manager could choose among.manager could choose among.

• But what should be the allocation weights across But what should be the allocation weights across the segments in the benchmark index? . . .the segments in the benchmark index? . . .


• No single general rule for benchmark segment allocation No single general rule for benchmark segment allocation weights.weights.

• Weights should be “Weights should be “appropriateappropriate”. Should reflect:”. Should reflect: Client’s objectivesClient’s objectives for the manager; for the manager; Manager’s specializationManager’s specialization and; and; Manager’s range of Manager’s range of discretiondiscretion over allocation policy. over allocation policy.

• General management principle involved is:General management principle involved is:

RESPONSIBILITYRESPONSIBILITY AUTHORITYAUTHORITY

EVALUATIONEVALUATION

Equate responsibility to authority, & evaluate accordingly.Equate responsibility to authority, & evaluate accordingly.


General implications:General implications:

• Peer universe sub-indexes should often be used to Peer universe sub-indexes should often be used to construct custom-weighted benchmark, with construct custom-weighted benchmark, with weights fixed weights fixed in advancein advance (i.e., NPI used only for benchmark (i.e., NPI used only for benchmark within-within-segmentsegment return performance). return performance).

• Example: Example: • Mgr hired to place capital into industrial & office properties at Mgr hired to place capital into industrial & office properties at her discretion:her discretion:• Benchmark = 50% NPI Office + 50% NPI Industrial.Benchmark = 50% NPI Office + 50% NPI Industrial.

• In absence of clear reason otherwise, simple equal-In absence of clear reason otherwise, simple equal-weighting may make sense.weighting may make sense.

• Typical mgr will avoid bet against benchmark, so Typical mgr will avoid bet against benchmark, so benchmark weight should reflect client’s allocation target benchmark weight should reflect client’s allocation target objective. (e.g., skew weights accordingly).objective. (e.g., skew weights accordingly).

Note:Note:

Previous general point about fixing benchmark weights Previous general point about fixing benchmark weights in advance to reflect client’s target objective for the mgr in advance to reflect client’s target objective for the mgr holds not only for market segment weighting in the holds not only for market segment weighting in the benchmark, but also for other characteristics of the benchmark, but also for other characteristics of the benchmark, such as the degree of leverage, the benchmark, such as the degree of leverage, the allocation across different styles (e.g., development allocation across different styles (e.g., development exposure), etc. (e.g., for benchmarking a multi-style exposure), etc. (e.g., for benchmarking a multi-style manager).manager).



• A reasonable (& popular) alternative is to use the peer A reasonable (& popular) alternative is to use the peer universe weights (e.g., NPI weights for the segments the universe weights (e.g., NPI weights for the segments the mgr has discretion to invest in).mgr has discretion to invest in).

• Rationale is “Rationale is “client investabilityclient investability” criterion:” criterion:- It’s what client would have gotten (ex ante) if they had - It’s what client would have gotten (ex ante) if they had

chosen a “typical” alternative chosen a “typical” alternative (competing) mgr.(competing) mgr.

Other alternatives for benchmark segment weighting:Other alternatives for benchmark segment weighting:


• Theoretical alternative: Use Theoretical alternative: Use market market weights – Share of weights – Share of each segment in total asset class market value.each segment in total asset class market value.

• Advantage of this approach:Advantage of this approach:• May reflect mgr’s relative ability to find available properties.May reflect mgr’s relative ability to find available properties.• May reflect relative ability of market to absorb new capital.May reflect relative ability of market to absorb new capital.

• Problems with this approach:Problems with this approach:• Since CAPM doesn’t work well for R.E., we don’t know if Since CAPM doesn’t work well for R.E., we don’t know if market weights are theoretically optimal from a portfolio market weights are theoretically optimal from a portfolio strategy perspective.strategy perspective.• Empirically it is difficult to precisely determine the market Empirically it is difficult to precisely determine the market weights.weights.

Other alternatives (cont.):Other alternatives (cont.):

Ch.23 & Ch.25: Valuation Methodology. . .Ch.23 & Ch.25: Valuation Methodology. . .

How asset & portfolio values are measured or estimated in How asset & portfolio values are measured or estimated in constructing the benchmark index (and also in computing constructing the benchmark index (and also in computing the subject manager’s performance record).the subject manager’s performance record).

• Fundamental issue relevant not just for benchmarking.Fundamental issue relevant not just for benchmarking.

• Issue that is unique and particular to private real estate.Issue that is unique and particular to private real estate.

Fundamental source of the problem is that in private real Fundamental source of the problem is that in private real estate markets:estate markets:

• uniqueunique, , whole assetswhole assets are traded are traded• infrequently and irregularlyinfrequently and irregularly through time, through time, • in deals that are privately negotiated between in deals that are privately negotiated between one one buyer and one sellerbuyer and one seller..

(All three of these characteristics differ from securities mkts.)(All three of these characteristics differ from securities mkts.)

IRR vs TWRR Benchmarking. . .IRR vs TWRR Benchmarking. . .

Benchmarking is an exercise in comparison of multi-period Benchmarking is an exercise in comparison of multi-period returns.returns.

Recall from Chapter 9 that there are two types of multi-Recall from Chapter 9 that there are two types of multi-period return measures (TWRR & IRR), and that:period return measures (TWRR & IRR), and that:

• TWRR is the standard performance measure in the TWRR is the standard performance measure in the securities industry and in traditional (“core”) real estate securities industry and in traditional (“core”) real estate investment.investment.

• TWRR is neutral with respect to the TWRR is neutral with respect to the timingtiming of capital flow in of capital flow in and out of the investment.and out of the investment.

• IRR reflects such timing, and IRR reflects such timing, and

• IRR can be computed without regular periodic “IRR can be computed without regular periodic “marking-to-marking-to-marketmarket” (appraisals).” (appraisals).

IRR benchmarking is the standard practice in the private IRR benchmarking is the standard practice in the private capital (e.g., “venture capital”) investment industry.capital (e.g., “venture capital”) investment industry.

It is also appropriate for performance evaluation in at least It is also appropriate for performance evaluation in at least two applications in the real estate investment industry:two applications in the real estate investment industry:

• Benchmarking certain types of Benchmarking certain types of “opportunistic”“opportunistic” real real estate investments, most notably estate investments, most notably development projectsdevelopment projects..• Property-level performance attributionProperty-level performance attribution of the type of the type described earlier in this lecture.described earlier in this lecture.

Because, in both cases:Because, in both cases:• The subject investments are often The subject investments are often not regularly marked-to-marketnot regularly marked-to-market, , andand• The responsible investment managers (whose performance is being The responsible investment managers (whose performance is being evaluated) are largely evaluated) are largely responsible for cash flow responsible for cash flow timingtiming decisions decisions that can significantly effect returns.that can significantly effect returns.



IRR-Based benchmarking requires the use of:IRR-Based benchmarking requires the use of:

Inception-date CohortsInception-date Cohorts

(or “Acquisition-date cohorts”).(or “Acquisition-date cohorts”).

• IRR is computed IRR is computed since inceptionsince inception (or acquisition) of (or acquisition) of portfolio (or property).portfolio (or property).

• IRR is computed for appropriate benchmark IRR is computed for appropriate benchmark cohortcohort, , defined as similar investments with same inception (or defined as similar investments with same inception (or acquisition) date, over same period of time as subject.acquisition) date, over same period of time as subject.

• Benchmark cohort IRR normally “Benchmark cohort IRR normally “pooledpooled” (all cash flows ” (all cash flows aggregated together each period).aggregated together each period).

• Terminal (current) value must be estimated for all assets Terminal (current) value must be estimated for all assets remaining in pool at end of evaluation period, based on remaining in pool at end of evaluation period, based on appraisalappraisal at terminal point in time. at terminal point in time.


In real estate, IRR-based benchmarking will often require In real estate, IRR-based benchmarking will often require the use of the use of simulatedsimulated IRR cohortsIRR cohorts as the benchmark, as the benchmark, because of lack of sufficient data.because of lack of sufficient data.

Chapter 27: Real Estate Investment Management Part II: Performance Attribution & Evaluation.

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Transcript of Chapter 27: Real Estate Investment Management Part II: Performance Attribution & Evaluation.