Future Shock

It’s dissertation time of year at UCL. I always learn something from every single dissertation that I supervise. As I read them again, I may draw some blogging inspiration from them. Natalia Kisielewska did something on whether the price changes in the public/indirect/listed real estate market provided a leading indicator of future price or appraisal changes in the private, direct real estate market. ‘Price’ is underlined and in bold to emphasise that the key issue is not really about whether current changes in the listed real estate sector tell us anything about future changes in appraisals. Most studies have found that changes in the prices of listed real estate vehicles tend to lead changes in values in the private real estate market recorded by appraisals.

Part of this lag is unavoidable since appraisals occur periodically (monthly, quarterly or annually) – so a market change mid-period can only be recorded when the appraisal takes place. Let’s call this appraisal lag. However, in addition, if appraisers rely on information from deals to estimate whether and/or how much the market has shifted, deals take a long time to occur in commercial real estate markets. Let’s call this transaction lag. So, this may also cause real estate appraisals to lag actual price changes. Transaction lag is also a problem because prices may be agreed months (typically 4-8 weeks) in advance of the completion or closure (when ownership changes hands and money is paid) of the transaction. So prices take much longer to form in and to disseminate through the private market.

More fundamentally, the key issue is the extent to which the two real estate investment markets are aligned. Given that many REITs are mainly asset holding vehicles, their values should change as the values of the assets change. However, owning REITs is not exactly like owning commercial property for lots of reasons. They offer liquidity (good) which often brings with it volatility (bad). The prices of REIT shares are changing almost continuously when trading is open. Given that there is no central trading platform, it’s unlikely that the prices of real estate assets can change continuously. Let’s try to look at it with a topical example.

Hopefully you can see below the changes that occurred in the share price of Land Securities at the beginning of September (courtesy of Prof Alex Moss). Given its size, Land Securities is usually regarded as a reasonable proxy for the UK listed real estate sector. As you can see, its share price dropped by nearly 5% in one day and then rose by over 3% the next day. Does this mean that the value of commercial real estate stock fell by nearly 5% and then rose by over 3% on that day?

Landsec

We have to allow for the fact that Land Securities is geared. In very basic terms…If they have assets worth £20 million and £15 million of debt giving a Net Asset Value of £5,000,000. A 5% fall in the value of the assets to £19 million will lead to a fall in the NAV (a rough proxy for the value of the company) to £4,000,000 a drop of 20%. If they had only £5,000,000 of debt and the NAV fell to £14,000,000, this leads to a fall in the NAV of 6.66%. So we also need to control for debt in the listed sector. I don’t know what the gearing is of Land Securities but you’d have to probably halve the price changes to take it into account.

So do the changes in the Land Securities share prices tell us anything about future changes in prices in the private market? Can it help us to buy underpriced assets and/or sell overpriced assets? Although markets can be inefficient, it would imply easy pickings for investors who spotted this phenomenon. So I’m suspicious. I suspect that the prices of real estate assets in the direct market are falling at the same time as prices in the indirect market but it’s the falling trees in the forest conundrum. If real estate values fall, but no-one observes them falling, did they really fall? In the Land Securities example, if prices subsequently rise later in September, any fall in asset values that occurred in early September will never be recorded in the end of September appraisals. This is getting complicated! I suspect that prices are lagging but that it’s difficult to get any advantage from it. For instance, if there are large rises in the values of REITs e.g. due to a positive shock such as a fall in Stamp Duty, typically the same factor will also change investor’s pricing in the private real estate markets but it simply takes longer for these new prices to emerge. It’s probably difficult but not impossible. With hindsight, many experienced investors can point to episodes when there was a disconnect between pricing in the two markets.

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