Investor Surveys & Weaknesses
Analyzing actual property transactions should provide the basis for discount rates and capitalization rates selected by real estate appraisers but this information is often difficult to obtain and confirm. Jim Clayton, David C. Ling, and Andy Naranjo point out that “observed cap rates may adjust more gradually to the arrival of new information because of numerous property market inefficiencies, such as high transaction costs, lengthy decision making processes and due-diligence periods, and informational inefficiencies.” Several companies publish information on real property discount rates, capitalization rates and expected equity returns on real estate investments. These surveys include RERC, RealtyRates.com, and PricewaterhouseCoopers Korpacz Real Estate Investor Survey. This information, along with alternative methods of developing these rates, can provide important insights to real estate investors’ expectations.
In developing the Land Investment Survey at Price Waterhouse LLP with my colleagues, Terry Grissom, PhD and Roger Grabowski, ASA, back in the 1990’s for litigation purposes and expert testimony and developing similar surveys for MacCrate Associates, I have learned the weaknesses associated with investor surveys. It is important for users to understand that there are weaknesses inherent in many of the investor surveys which can affect the final valuation conclusions.
The authors mentioned above stated “Similar to the RERC survey, the KPC survey (PricewaterhouseCoopers Korpacz Real Estate Investor Survey) consists of quarterly responses from 100-odd prominent pension plans, foundations, endowments, life insurance companies, investment banks, and REITs that invest in U.S. real estate. These companies do not invest in Sea Cliff, New York, Waterville, Maine, Romeo, Michigan, and similar locations. They are investing in New York, Chicago, Atlanta, San Francisco and growing suburban communities. Therefore, is the information developed on the expected equity yield rates, capitalization rates and discount rates in these surveys relevant for most appraisal assignments completed for lending institutions, tax assessment and litigation purposes? The respondents in the surveys mentioned are typically institutional investors interested in better grade investment properties. These surveys must be used with caution.
In a recent online seminar offered by the Appraisal Institute, Timothy E. Mardell, MAI, CCIM stated that it was extremely important for real estate appraisers and lenders to contact local and regional real estate brokers and leasing agents who may be excellent sources for information on transactions, capitalization rates and discount rates. Generally, tenant risks are higher in smaller communities and the demand for local investment properties is limited. One of the most reliable methods is either to conduct a local investor survey or refer to one that is developed locally. In many smaller, geographical and secondary locations reliable surveys are not often available. The returns expected by investors should be much higher than indicated in the professional surveys but that is not always the case though.
For real estate appraisers to utilize and rely on investor surveys, it is important to understand the methodology employed by the organization conducting the survey and the definitions of the terms employed in the survey. Many survey respondents do not understand what a capitalization rate or a discount rate is. That is not the respondent’s function at some of the firms who complete the survey. The total number of and the qualifications of who responded are important to consider.
Many investors only deal in one specific geographical region or city. For example, there are many active investors in Manhattan who do not invest on Long Island or in Philadelphia. The returns expected in Manhattan may not be applicable to investments in Philadelphia or on Long Island. Real estate markets are also segmented by property type. For example, the Urban Land Institute divides retail properties into many categories, such as regional malls, community and neighborhood centers. The risks associated with each property type are different. The reported expected capitalization rates and discount rates are different.
While there are standard chart of accounts for most property types, many investors have their own standard for accounting for gross revenues, expenses, reserves for replacement and capital expenditures. Therefore, they may calculate the expected capitalization and discount rates differently. This makes it difficult to compare one respondent’s answer to a question directly to another respondent’s answer. Unless, the real estate appraiser conducted the survey directly, they may not fully understand the nuances of all the respondents’ answers.
There are many assumptions implied in the expected capitalization rate and discount rate. These rates are influenced by many factors, including but not limited to, the tenants’ credit ratings, length of leases, rental and expense growth rates, terminal capitalization rates, calculation of reserves for replacement and investment holding period. The analysis of this information must be consistent to produce reliable results that can be obtained from a survey. There is an expected mathematical relationship between the discount rate and the overall capitalization if it is properly and consistently extracted from the respondents’ answers to the investor survey. Surveys are useful in establishing the ranges of expected returns by investors on income producing real estate, especially when market information is limited or non-existent.
 Clayton, Jim, Ling, David C. and Naranjo, Andy, Commercial Real Estate Valuation: Fundamentals Versus Investor Sentiment (April 2008). Available at SSRN: http://ssrn.com/abstract=1132361