Estimating quality adjusted commercial property price indexes using Japanese REIT data

Abstract

We propose a new method to estimate quality adjusted commercial property price indexes using real estate investment trust (REIT) data. Our method is based on the present value approach, but the way the denominator (i.e. the discount rate) and the numerator (i.e. cash flows from properties) are estimated differs from the traditional method. We run a hedonic regression to estimate the quality adjusted discount rate based on the share prices of REITs, which can be regarded as the stock market’s valuation of the set of properties owned by the REITs. As for the numerator, we use rental prices associated with all existing contracts, as well as rental prices associated with new rental contracts, which may contain more information on future cash flows from properties. Using a data-set with prices and cash flows for about 400 commercial properties included in Japanese REITs for the period 2001–2013, we find that our price index signals turning points much earlier than an appraisal-based price index; specifically, our index peaks in the second quarter of 2007, while the appraisal-based price index exhibits a turnaround only in the third quarter of 2008. Our results suggest that the share prices of REITs provide useful information in constructing commercial property price indexes.

Keywords:

• REIT
• quality adjusted price index
• hedonic regression
• Tobin’s q
• risk premium

JEL Classifications:

• E3
• G19

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1. The handbook is available online at: http://epp.eurostat.ec.europa.eu/portal/page/portal/product_details/publication?p_product_code=KS-RA-12-022.

2. J-REITs differ from REITs in the US and the UK, where individual property information is not disclosed.

3. See Shimizu, Nishimura, and Watanabe (2010a) for details on the discrepancy in rental prices between new contracts and existing contracts in the case of residential properties.

4. The amount of office investment via REITs for Japan is 4.6 trillion yen, accounting for 49% of overall property investments. According to estimates by International Property Databank (IPD), as of March 2012, the corresponding figures were 34% for the US, 30% for the UK, 52% for France, 45% for Germany, and 44% for Australia. See, for example, Ooi, Newell, and Sing (2006) and Ooi, Ong, and Neo (2011) for more on REIT markets in Japan and other Asian countries.

5. See Geltner and Pollakowski (2007) for a survey on this issue.

6. See Quan and Quigley (1991), Geltner and Kluger (1996), Clayton, Geltner, and Hamilton (2001), and Francke and Vos (2004) for discussions of the sources of valuation errors and excessive smoothness of appraisal price-based indexes. According to these studies, property appraisers fail to acquire price data in a timely manner. Also, they tend to update prices only with a lag due to their slow decision-making process. In a related context, Shimizu et al. (2012) point out that appraisers tend to regard large price changes as outliers and therefore tend to exclude them. Shimizu et al. (2012) argue that this at least partly contributes to excessive smoothness.

7. An additional systemic factor in appraisals of investment properties is that price appraisals may be subject to interference from the client. As highlighted by Crosby, Devaney, Key, and Matysiak (2003) and Crosby, Lizieri, and McAllister (2010), clients may seek to persuade property appraisers to raise the price in an attempt to maintain the property’s investment performance.

8. See Diewert (2007) and Shimizu, Nishimura, and Watanabe (2010b) for some estimation issues associated with the repeat sales method, including the change of building quality over time due to depreciation and renovation.

9. Appraisal prices of properties owned by J-REITs must follow a rule set by the government, which is referred to as ‘Securitized Property Appraisal Standard’. It requires REITs to employ DCF (discounted cash flow) method. Details on the procedure to calculate revenues and expenses are also specified in the standard.

10. Rentable floor space refers to the building floor space within a building that represents a source of income. Shared areas such as the entrance as well as areas of the building not included in the transaction are eliminated from this.

11. Equation (2(2) $$v_{it}=E_t\sum _{r=0}^{\infty }\frac{y_{it+r}}{\text{exp}\left({\sum }_{s=0}^{r-1}{r}_{i,t+s}\right)}=y_{it}{\mathit{\varphi }}_{it},$$(2) ) defines the fundamental value of property i. However, we can easily incorporate the possibility of property bubbles into the model. As an extended version of (2), let us assume that the price of property i consists of the fundamental component and a bubble component, and that the bubble component depends only on t but not on i. Then, Equation (2(2) $$v_{it}=E_t\sum _{r=0}^{\infty }\frac{y_{it+r}}{\text{exp}\left({\sum }_{s=0}^{r-1}{r}_{i,t+s}\right)}=y_{it}{\mathit{\varphi }}_{it},$$(2) ) changes to $v_{it}=y_{it}{\mathit{\varphi }}_t+b_t$, where b_t represents the bubble component. The methodology developed in this section basically remains unchanged even in that case. See Diewert and Shimizu (2013) for more on this.

12. The relationship between required rate of returns and firm characteristics has been discussed in the asset pricing literature. For example, Chordia, Goyal, and Shanken (2012) shows that a appreciable portion of cross sectional variations in stock prices can be accounted for by firm characteristics.

13. The Securities Listing Regulations of the Tokyo Stock Exchange (as of 10 May 2012) state: ‘The ratio of the amount of real estate, etc., to the total amount of the working assets, etc., is expected to reach 70% or more’ (Rule 1205 (1) a) and ‘the ratio of the total amount of real estate, etc., real estate-related assets and current assets to the total amount of the working assets, etc., is expected to reach 95% or more by the time of listing’ (Rule 1205 (1) b). In this respect, J-REITs differ from REITs in the US and the UK, where REITs are allowed to own not only properties themselve but also other assets, including the shares of real estate companies.

14. This eclectic approach is similar to the one advocated by Geltner and Kluger (1996) and Horrigan, Case, Geltner, and Pollakowski (2009). Geltner and Kluger (1996) and Horrigan et al. (2009) propose a method in which REIT returns are delevered and then regressed against property attribute data. Specifically, they first calculate delevered returns for REIT r as a weighted average of REIT returns (i.e. the growth rates of the share price of REIT r) and the debt interest rate with weights given by e and 1 − e, where e represents the fraction of equity in total assets. They then estimate an equation of the following form: $\text{delevered}{\text{return}}_{rt}={\sum }_j{\mathit{\theta }}_{jt}{x}_{jrt}$, where x_jrt represents REIT r’s percentage of total assets in various market segments (j) such as the apartment, industrial, retail, and hotel market segments. Note that the dollar value of assets in a REIT’s portfolio is unknown, so that they use proxies for property value such as rental income or floor space. The regression coefficient θ_jt represents the return for market segment j.

15. Shimizu et al. (2010a) apply a Calvo model to rental prices of residential properties to find that an equation like (14) fits the data well.

16. See Tobin (1969) and Hayashi (1982). Hayashi and Inoue (1991) estimate Tobin’s q for Japanese firms by explicitly accounting for the value of properties owned by firms.

17. These four REITs specialise in investing in office buildings only and, more importantly, most of those office buildings are located in Tokyo. Moreover, the parent companies of the four J-REITs (Mitsui Fudosan, Mitsubishi Estate, Nomura Real Estate Development, and Meiji Life Insurance) all have a high credit rating, so that the stock prices of the four J-REITs do not depend much on factors other than the performance of their investments in commercial properties.

18. According to Gentry and Mayer (2006), the mean and the standard deviation of Tobin's q in US REITs in 1992–2002 are 1.04 and .12, respectively.

19. Gentry and Mayer (2006) shows that REITs tend to increase investment, which is defined as the percentage change in total assets during the year, when Tobin’s q is greater than unity. Specifically, their regression result indicates that a REIT whose q rises from 1.0 to 1.1 increases its assets by 4.3% in the next year. It is our future task to compare the sensitivity of REIT investment to q between US and Japanese REITs.

20. Crosby et al. (2010) argue that investment companies that manage REITs have different incentives to update property valuations depending on whether prices are rising or falling. That is, during periods when the property market is heating up, investment companies have an incentive to increase property prices appropriately in accordance with changes in the market. On the other hand, when the market is falling, investment companies have an incentive to urge property appraisers not to lower property appraisal prices in order to maintain their loan-to-value ratio within a certain range. Our finding that appraisal prices were not updated fully when property prices were on an upward trend is inconsistent with this story.

21. It is assumed in the Calvo model that price adjustment follows a Poisson process. Specifically, a typical rental contract is renewed with probability 1 − λ, so that the probability that a contract survives exactly τ periods is equal to λ^τ−1(1 − λ). Thus, the expected lifetime of a contract can be computed as ${\sum }_{\mathit{\tau }=1}^{\infty }\mathit{\tau }\times {\mathit{\lambda }}^{\mathit{\tau }-1}(1-\mathit{\lambda })=1/(1-\mathit{\lambda })$.