Measurement Error in FRC/NCREIF Returns on Real Estate

Abstract

The problem of measurement error in the Frank Russell Company/National Council of Real Estate Investment Fiduciaries (FRC/NCREIF) real estate returns series is quite clearly an important one. This returns series purports to track the performance of real estate investments made by large institutional investors. But, in practice, measurement errors are likely to occur since the returns are based on appraised values, not on market prices. One recent contribution, that of Geltner [3] and Giliberto [4], suggests that the problem of measurement error in the FRC/NCREIF returns series is apt to make it appear as if real estate offers higher returns and lower portfolio risk than stocks or bonds. Geltner [3] and Giliberto [4] propose testing for the existence of measurement errors in the FRC/NCREIF returns series by measuring the extent to which appraised values depart significantly from market prices. A more practical test procedure is to treat the problem as an errors in variables problem and specify an inventory demand model for commercial real estate put in place in which the FRC/ NCREIF returns series, as a proxy for the return on real estate, shows up as an explanatory variable. The appeal of this estimation procedure lies in the fact that, although it is in the spirit of Geltner [3] and Giliberto [4], it does not require the analyst to postulate how changes in appraised values are related to changes in market values; rather, the idea is to evaluate the measurement errors in the FRC/NCREIF returns series by assuming that the relationship between the inventory demand for commercial real estate put in place and the return on real estate is a deterministic one, and that the only reason why we observe some unaccounted for variation in the dependent variable is that we do not have exact measurements of the inventory demand for commercial real estate put in place or the return on real estate. For suitably defined parameter estimates, the ratio of the asymptotic error variance in the FRC/NCREIF returns series to the true return variance on real estate can then be obtained by separating out the effects of errors associated with the regression model and measurement errors. It then goes without saying that the larger the variance of the measurement error in the FRC/NCREIF returns series relative to the variance of the true returns on real estate, the less reliable the FRC/NCREIF returns series is in assessing the performance of real estate investments relative to stocks and bonds. Conversely, when the proportion of the variance in the FRC/NCREIF returns series to the variance in the true returns on real estate is small, the theoretical returns on real estate and the FRC/NCREIF returns series may be close enough that the difference is of no real consequence in assessing the diversification advantage of real estate. The problem becomes crucial only when the variance of the measurement error in