Types of Real Estate Indices
A number of types of real estate indices are used to track the performance of real estate including appraisal-based indices and transaction-based indices. Investors should be aware of how the indices are constructed as well as their limitations.
On this page, we discuss private equity real estate investment indexes, including their construction and potential biases. In particular, we discuss appraisal-based indices and transaction-based indices.
Because real estate transactions covering a specific property occur infrequently, indices have been developed based on appraisal values.
Appraisal-based indices combine valuations of individual properties that can be used to measure market movements. A popular index in the United States is the NCREIF Property Index (NPI). Members of NCREIF, mainly investment managers and pension fund sponsors, submit appraisal data quarterly, and NCREIF calculates the returns as:
The index is then value-weighted based on the returns of the separate properties. The return is known as a holding-period return and is equivalent to a single period IRR.
The index allows investors to compare performance with other asset classes, and the quarterly returns can be used to measure risk (standard deviation). The index can also be used by investors to benchmark returns.
Appraisal-based indices tend to lag actual transactions because actual transactions occur before appraisals are performed. THus, a change in price may not be reflected in appraisal values until the next quarter or longer if a property is not appraised every quarter. Also, appraisal lag tends to smooth the index; that is, reduce its volatility, much like a moving average reduces volatility.
Finally, appraisal lag results in lower correlation with other asset classes. Appraisal lag can be adjusted by unsmoothing the index or by using a transaction-based index.
Transaction-based indices can be constructed using a repeat-sales index and a hedonic index:
- a repeat-sales index relies on repeat sales of the same property. A change in market conditions can be measured once a property is sold twice. Accordingly, a regression is developed to allocate the change in value to each quarter.
- A hedonic index requires only one sale. A regression is developed to control for differences in property characteristics such as size, age, location, and so forth.
We discussed two popular private equity real estate investment indexes used by pension funds and investment managers.