...portfolio. approach is applied to commercial real estate, where we create an index of REIT returns to compare to the NCREIF index. To enhance comparability, return indices are adjusted for partial-year financial data, leverage, asset mix and fees. Adjusted results over 1980-1998 sample period show general convergence between the indices, although an annual return difference of over three percentage points remains in favor of public market asset ownership. Possible causes of the investment performance gap include liquidity and geography as missing risk factor adjustments, an unrepresentative sample period, and the form in which commercial real estate assets are held.

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Analysts often use asset pricing models to measure investment performance and to compare individual stocks or portfolios of exchange-traded securities. The classic single-factor capital asset pricing model (CAPM) is an example. In this model an estimated beta characterizes priced risk and determines predicted investment performance. Performance assessment occurs by comparing actual returns to predicted returns. Asset pricing models are also useful to compare investment characteristics and performance across financial assets. For instance, performance is often compared to a risk-adjusted reference portfolio or index to assess whether a fund manager was lucky or good when excess investment returns are realized.

Comparative performance assessment using a classic asset pricing approach can be inappropriate in a private market setting, however. Consider the case of commercial real estate. Privately held commercial real estate assets are often nontraded for extended periods and are sufficiently unique as to make value estimation difficult. A further complicating factor in comparing returns is the going concern aspect of publicly traded firms. Because publicly traded firms are going concerns, equity share values will reflect the present value of future growth opportunities over and above growth opportunities associated with assets in place. These growth opportunities can be positive or negative, and their value changes are often correlated with returns to the index (e.g., market) portfolio. This going concern effect does not factor into private-directly held assets, whose values reflect only expected cash flows directly associated with the asset.

Although problematic, investors are nevertheless often interested in assessing private-direct market investment performance and comparing it to publicly held asset performance. We suggest a simple alternative approach to the standard asset pricing method. The basic idea is to adjust the risk characteristics of assets underlying one portfolio to match the risk characteristics of assets underlying another referencing portfolio. Our approach is essentially nonparametric, since we take no a priori position as to which types of risks should be priced. Rather, we simply attempt to identify and adjust for risk characteristic differences wherever they occur in the data.

We apply our methodology to compare the investment performance of privately and publicly held commercial real estate as proxied by the National Council of Real Estate Investment Fiduciaries (NCREIF) index and a self-constructed index of publicly traded equity REITs. We gather firm-level equity REIT return data over a 19-year period, spanning from 1980 through 1998. Firm-level returns are size weighted to create an index of annual returns, which are then compounded and geometrically averaged to produce an average annualized return. Before making any adjustments, REIT index returns to equity are found to equal 12.50% on average. This compares to an average return to the NCREIF index over the same period of 8.51%--a difference of four percentage points per year. (1)

We adjust the indices to account for four major risk/data measurement effects: partial years, leverage, asset mix and asset management fees. First there are performance differences for young firms, or those that experience merger, acquisition or financial distress. To avoid distortions we eliminate firms with partial year financial data. Second, we adjust for leverage. NCREIF returns are reported on an unlevered basis, while REITs are levered. Third, we adjust for risk differences in types of properties underlying each index. Adjusting for differences in property type is important, as equity REIT holdings are biased to-ward retail and noncore property types, while NCREIF assets are biased toward office and industrial property. Finally, we adjust for treatment of fees. NCREIF returns are reported prior to investment management fees, whereas REIT return results include management fees.

These adjustment result in annualized returns of 7.36% for the index of privately held assets and returns of 10.44% for publicly held assets--an investment performance gap of 3.08 percentage points per year in favor of publicly held commercial real estate assets.

Thus, there is an overall convergence between the REIT and NCREIF indices after adjusting for major risks and accounting differences. The investment performance gap of three percentage points per year remains rather large, however. We can think of three potential explanations for the gap. First, we may not have identified some important risk factors. Liquidity and asset location are two possible factors that merit further attention.

Second, the sample period may not be representative of investment performance fundamentals. Two favorable (perhaps one-time) events occurred during the sample period to favor REITs: (i) In 1986 tax laws were modified to allow REITs to manage themselves internally and (ii) poor private market performance and liquidity problems in the commercial real estate sector in the late 1980s/early 1990s strongly favored REITs, which had access to liquidity when the private market did not. (2)

A third possible explanation is that public market ownership of commercial real estate assets may simply be more efficient than private ownership. A number of arguments have been floated as to why, including economies of scale, transparency gained from analyst coverage and the distribution of audited financial statements, the discipline of quarterly reporting and accessing capital through SEC-registered security offerings and value-enhancing liquidity and standardized security design.

Sorting out these effects is important, as there are deeper economic questions related to which market provides the more efficient ownership vehicle. It may be that the corporate/securitized form of ownership is more efficient than private-direct ownership, leading to better risk-adjusted investment performance. If true, it has broad implications for consolidation and asset ownership structure in the longer run. Furthermore, whatever the reasons for the investment performance differential, our perspective is that a viable public market for asset ownership is beneficial for the broader commercial real estate space and asset markets. Real-time price discovery in exchange-traded markets spills over into illiquid private markets to temper boom-bust tendencies and otherwise improve the allocation of resources.

The main body of this article is organized as follows. First we consider related literature. We then describe our data and REIT index construction methodology, and REIT returns are calculated. Adjustments are made to the data to enhance comparability. Based on the final adjusted results, we then attempt to explain remaining differences in investment performance. The article ends with a summary and concluding comments.

Literature

Classic Asset Pricing Models and Performance Measurement

The pricing of exchange-traded assets begins with the one-period single-factor capital asset pricing model of Treynor (1961), Sharpe (1964), Lintner (1966) and Mossin (1966). The basic model has been extended to account for multiple pricing factors (Ross 1976), intertemporal asset pricing (Merton 1973) and consumption-based pricing (Lucas 1978, Breeden 1979). Classic asset pricing models have had a huge impact in economics and in the real world because they are intuitive and easy to interpret due to their linear representations.

The basic idea behind all asset pricing models is that nondiversifiable (systematic) risks are priced by investors, while diversifiable (idiosyncratic) risks are not priced. Expected asset returns are calculated as a premium (or potentially a discount) to a riskless benchmark asset, where the risk premium depends on how the asset covaries with the relevant factors (e.g., the market portfolio) as summarized by the model's "beta(s)."

A crucial characteristic of classic asset pricing is that model betas are sufficient statistics for hedging or otherwise replicating uncertain investment outcomes. In the case of complete financial asset markets, a linear combination of financial assets can be found to exactly replicate the returns to...

NOTE: All illustrations and photos have been removed from this article.



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