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Real estate investment decision making – a review
Article Type: Practice briefing From: Journal of Property Investment & Finance, Volume 30, Issue 5
Over recent decades the asset class real estate has become increasingly important throughout the world. This trend is shown through the increasing professionalism in asset management. For third parties, it can be very difficult to understand why an investor selected a specific investment over another. The investment criteria in terms of risk and return appear to be obvious, but still the whole decision process is relatively opaque for an outsider.
The paper will analyse what decision models are available for real estate portfolio managers. It will introduce the reader to basic concepts of portfolio management and their applications to real estate. The paper will examine if the theoretical decision models (normative) and the practical real life decisions in portfolio management match in the UK property market.
General decision making theory
Generally speaking decision theory is concerned with the analysis of judgements. This theory seeks to lead to a profound and rational decision and derives from a variety of subjects, such as philosophy, mathematics, economics and social sciences, including psychology and sociology (Ricciardi and Simon, 2000). Generally speaking decisions are very important for every responsible person throughout life. In particular, the business and investment world is highly dependent on responsible decision making. In order to come to a rational and profound decision a decision analysis should be undertaken.
Howard (1988) describes decision analysis as “a schematic procedure for transforming opaque decision problems into transparent decision problems by a sequence of transparent steps”. Hence, this kind of analysis should assist the applicant to overcome confusion and to get a clearer understanding of possible outcomes. Although the basic idea of decision analysis was established many centuries ago most individuals often do not apply a proper decision analysis. The main reason for that lies in human nature. People generally are inured to make use of heuristics and intuitive reasoning (French and French, 1997).
One way to overcome this problem is the establishment of models which either describe how decisions are made or give specific instructions on how to come to a decision. A further decision model uses both methods. Therefore, decision models can be distinguished into three categories:
Normative models focus on the question how decisions should be made. Hence, they give investors a framework as to how they should come to a rational decision. In order to simplify the model it is assumed that people act completely rationally in accordance to their utility function.
By way of contrast, descriptive models analyse how in practice these decisions are made (French, 2001). This is possible through the application of empirical research.
If the new findings of empirical research are incorporated in a model it is labelled as a prescriptive model. This model is there to overcome the gap between the normative and descriptive models. The main attribute of this model is that it allows findings of descriptive studies to be taken into account in a new normative model. This is possible because the decision maker can adjust findings of previous descriptive studies in his/her sensitivity analysis.
Property decision making theory
In order to illustrate the most important actions during a typical investment decision process the following steps should be highlighted (according to Hartigay and Yu (1993)):
Definition of purpose and objectives of the real estate portfolio.
Formulation of a specified strategy and their selection/assessment criteria.
Assessment of individual projects against the predefined criteria and strategy.
Closer examination of projects that meet return and risk profile.
Closing the investment decision and implementation of actions.
Post auditing and optimising (link to step 1).
It should be noted that there are differences between the decision making models throughout the literature. There are models which were specially created for a typical investment decision process and models which were designed for a broader application. The four stage models of Roulac (1994) and Brown and Matysiak (2000) derive from capital budgeting rather than from investment decision making. The difference between both budgeting models is that Roulac provides a decision phase, whereas Brown and Matysiak offer an implementation (3) and auditing phase (4) but no actual decision phase. In this context, it is to be noted that several models are missing important decision making steps. In a similar way to Roulac (1994) the models of Jaffe and Sirmanns (2001) and Baum (2002) both stop the decision process after an investment decision has been made.
All of the above models have a sequential structure. Only a few authors recommend that their decision process should have a circular structure. Hartigay and Yu (1993) indicated the need for a circular structure, which is suggested in their last step (conclusion, revise goals). Figure 1 should show an ideal decision making process which should be comprehensive but still connected to the most important grouping activities.
The so-called “definition phase” should define the investment strategy of an investment fund. Hence, this phase should establish tangible objectives, mostly in regard to the risk and return. Farragher and Savage (2008) notice that, from an empiric point of view, many investors tend to have not quantified their risk standard. However, it must be noted that this phase is essential for the further investment process so it is crucial that all details are precisely outlined and communicated throughout the organization. The following phase is the “planning phase” which generally tries to define the previously established objectives more precisely. Therefore, the concrete guidelines regarding the analysing and searching phase are established. Further on this phase includes an evaluation of the general environment, including a market overview. By way of contrast, the “dealing phase” is concerned with the search for and evaluation of suitable investment projects. It includes the forecasting and evaluation of all relevant investment criteria (return, risk, legal, tax, etc).
The executing phase is mainly focused on the actual decision making. This phase contains the final approval of an investment board. Only if all relevant criteria are fulfilled a project will pass this phase. If this is not the case then the process will be regressive in order to adjust the predefined and planned objectives or to start the investment search again. This phase also involves the deal structuring and negotiation.
The next step is the watching phase which is mainly concerned with the measurement and controlling of the investment. This phase then leads to the optimising phase which will analyse the strengths and weaknesses of the investment property. This phase may either lead to an advancement of the investment property or, conversely, to a disposal. It is important to highlight that this phase is interrelated to the first phase which emphasizes the circularity of the investment process. Whether the investment was successful or not, the decision will be evaluated to ascertain if the definition phase needs any adjustments for future.
Definition of portfolio management
Portfolio management is concerned with the asset allocation of the overall portfolio. Here, the fund manager can choose between various types of assets such as stocks, bonds, real estate and other investments. Formulating objectives and an asset allocation policy with regard to the portfolio is a key task of the portfolio management (Nieboer, 2004). With regard to the real estate allocation the portfolio manager can choose between various property types (commercial, offices, industrial, etc).
In contrast asset management focuses more on the management of the individual assets, meaning it focuses on decisions relating to a property such as the refurbishment, improvements and disposals. This operation also focuses on performance analysis, pricing and marketing of properties. Generally speaking the objective of real estate asset management (REAM) is the successful application of the predefined strategy of the portfolio level (Fuerst, 2009).
Dubben and Sayce (1991) state that property management deals with the day to day management of properties. The property manager acts on the behalf of the landlord and has certain tasks to fulfil which can include rent collection, lease management and arranging maintenance and repair works. To distinguish this activity from asset management, the property manager generally does not consider the performance (return) of the property.
Objectives of portfolio management
One of the first things to do in portfolio management is to set out objectives. These can be either in accordance with company regulations (liquidity requirements, etc.) or with the preferences of the investor. These preferences focus on variables like return, risk and liquidity. Time is a very relevant factor in regard to all three variables and the relation between these objectives must be analysed. Generally the variables risk and return follow the same trend, by taking a higher risk the investor expects a higher return. Conversely, liquidity and risk follow contrary paths since the higher liquidity of an asset can contribute towards a lower risk. The time frame of an investment must also be considered. On a long-term basis the investor may be looking for a safe (low return and low volatility) investment. However, the investor may also opt for a riskier investment over a shorter time period.
Background of real estate portfolio management
Since portfolio management has a variety of different approaches, some definitions should be established. Stier (2010) concludes that it should be distinguished between portfolio construction, portfolio planning and portfolio policy.
In context to portfolio construction the bottom up approach and the top down approach must be mentioned. The bottom up approach is adopted to analyse an existing real estate portfolio. Generally the approach examines how the portfolio can be positively restructured. Fuerst (2009) mentions that it is very unrealistic to restructure historically grown portfolios according to a benchmark. The main reasons behind that statement are the characteristics of the asset real estate, mainly due to the lot size, illiquidity and transaction costs, making it very difficult to match a benchmark.
On the other hand the top down approach is only applied when constructing a new portfolio on the basis of stochastic calculations. Since the portfolio is created from scratch it is generally possible to track benchmarks or to apply “efficient” allocation choices. Since most investors already have an existing real estate portfolio the bottom up approach is more relevant in practice.
Whilst talking about portfolio policy, one must be aware of the difference between the active and the passive approach. Wellner (2003) highlights that the passive approach is based on the idea that the market is efficient. This means that an individual investor generally will not be able to beat the market in the long run. This implies a buy and hold strategy which can generate appreciations through inflation and positive market trends. The active approach is based upon the opposite view which is that a good active management policy must be able to beat the market.
Modern portfolio theory and other normative theories
Markowitz portfolio theory
Before Harry M. Markowitz introduced his mathematical approach in 1952 it was commonly known that investors can benefit from naive diversification (Markowitz, 1952). Hoesli and McGregor (2000) notice that main feature of the Markowitz portfolio theory (MPT) theory is that investors can increase their expected utility (risk and return) by applying statistical diversification. Through having the right proportion of each asset in a portfolio it is possible to exclude all suboptimal risk and return combinations. This process of increasing the utility level is possible in the following two ways:
The output can maximize the return in respect to a given level of risk.
The output can minimize the risk by a given level of return.
In order to get such proportions of optimal asset weightings, the first thing to ascertain is to compute the expected risk and return of each asset. Further on it is to examine how each of the assets correlates to each other. Finally, through the application of Langrange multipliers it is possible to solve the optimization problem (Amu and Millegard, 2009). The result can be highlighted as the efficient frontier, which includes all optimal sets of portfolio combinations.
One major criticism of the modern portfolio theory is that it “only” uses historical or estimated input data to examine the optimal allocation. It is obvious that fund managers need to find optimal asset combinations for the future and not for the past. On this subject, Sharpe (1990) noticed that the MPT is most useful for standard deviation and correlation analysis but relatively useless for expectation of returns (Hoesli and McGregor, 2000). Further on since asset allocation decisions are not made as often by investors it is worth mentioning that the theoretical “optimal” asset allocation can change over time quite quickly.
Lee and Stevenson (2005) identify that possible results of optimal allocations might have extreme allocation results which are for a portfolio manager difficult to follow. Also since these extreme allocations result from past data, the requested diversification effect can be diminished, since time can change the optimal allocation easily.
Hoesli and McGregor (2000) point out that the determination of investor’s preference can be difficult, since not all investors prefer to have the optimal risk and return allocation and might also orientate on other issues like liability matching. Discussing the theoretical framework it is obvious that this model is restricted to various assumptions which are not applicable in real life. For example, the framework does not allow hedging vehicles like lending, borrowing and short sales which are generally good practices in portfolio management.
The following issues are particularly relevant to real estate investments but some of them might be also valid in general. First, the theory does not incorporate any transaction costs. In regard to stocks these costs might be negligible but the transaction costs in real estate are considerably higher. In this context, another problem is the illiquidity of real estate assets. The MPT theory assumes liquid assets, since this model was first developed for the stock market. The real estate market is a relatively illiquid market and it takes time and money to sell real estate assets.
Capital asset pricing model
The capital asset pricing model (CAPM) model is a supplement to the portfolio theory, which was developed by Sharpe, Treynor, Litner and Mossin (Perold, 2004). This theory examines the rate of return of an individual asset in regard to the market risk Beta. The theory introduced the concept of the security market line (SML), which should give evidence how the market would price a single asset in relation to the return and the systematic risk. Hence, this model verifies the important input parameter return for the MPT theory.
With regard to the CAPM it must be said that this method can be used for the estimation of discount rates. Here, one must point out that since not all real estate investors are public traded companies it will not always be possible to find an appropriate beta figure. Baum (2001) notices that the beta factor generally implies the risk of the past for the estimation of future returns. However, since this method is widely used in the corporate finance world it is generally applicable for Real Estate Investment Trusts (REITs). In the general real estate practice they mostly rely on the estimation of discount rates from empirical surveys.
Another important issue on this topic is the general availability of data about time and quality. Some developed markets, the US and the UK in particular, offer a good basis (according to JLL transparency index). In respect to individual real estate assets it is very difficult to forecast appropriate inputs. General benchmark indices like the IPD all property index are appraisal based, so therefore this data cannot be evaluated as market evidence.
All these factors indicate that the general portfolio theory can possibly give good advice on asset allocation for a mixed asset portfolio. It is possible to estimate what proportion of the investment budget should be allocated to real estate, so that diversification benefits can be applied. These theories are not devised for real estate investments and they offer little benefit for asset allocations on the real estate level.
However, the real estate practice has several practical techniques to analyse whether an investment is preferable or not. The following part will give a brief overview of the most relevant practical decision techniques.
Practical decision models
The following section will give, in contrast to the previous theoretical models, an overview of the most relevant practical normative decision models.
Return on investment
The return on investment (ROI) is a static metric which is commonly used because of its simplicity and comparability. As equation (1) illustrates, it divides the net benefit of an investment with the costs of an investment. As illustrated, the ratio is also defined as Earnings before Interest and Taxes divided by total assets:
This method can be used for the fast and approximate evaluation of an investment. Nonetheless, this method does not take compound interest and the time value of money into account.
Discounted cash flow approach
One of the most important factors in a property is the underlying cash flow. Generally speaking the discounted cash flow approach (DCF) model can value the cash flow over time and can estimate what value the property has currently. As Geltner et al. (2007) notice the appraisal is based on the assumption that the market value is equal to the net present value (NPV) of the future returns. The following formula exhibits the NPV formula:
Whilst using this formula it must be highlighted that the exit value of the potential sale of the property must be incorporated into the cash flow. In order to estimate the NPV various data must be incorporated accurately into the model, particularly the discount rate (required rate of return), which is crucial for the estimation of the NPV. It must be pointed out that many input parameters (rent, discount rate, exit yield, etc.) have a strong influence on the NPV, so therefore, the proper estimation of these figures is crucial in order to obtain a reliable result.
Generally speaking it can be concluded that if the DCF has a positive NPV it can be evaluated as a lucrative investment. The different investment properties should be compared and the one with the highest NPV should be preferred (only in regard to this criterion). This rule is only applicable if the capital outlay of each of property is the same. The investor also has the option of adjusting the DCF parameters in order to make the results comparable. Nonetheless, it is possible to compare the results of different capital structures by using the benefit/cost ratio. This approach can be achieved “by dividing the discounted present value of the total benefits to be obtained from a project by the discounted present value of its total costs” (Enever et al., 2010).
However, by using the net cash flow it is possible to estimate the internal rate of return (IRR). The following section will highlight the advantages of the IRR as a return figure.
Internal rate of return
In comparison to the previous mentioned return figure (ROI), the IRR has the ability to take the time value of money into account. It is defined “as the rate of return which equates the present value of the cash outflows to the present value of the cash inflows” (Brown and Matysiak, 2000). Therefore, the NPV equation is equalled to zero in order to solve the rate of return (r) by using an iterative technique:
ct = cash out in t, at = cash in flow.
Although the IRR has some conceptual drawbacks such as the liability to the number of sign changes, it is still the most frequently used return figure. One reason for that is if it is assumed that there is only one sign change, this method provides the opportunity to compare projects easily. The general decision rule of this technique is that the project with the highest IRR should be accepted if it exceeds the opportunity costs of capital.
The previous mentioned normative models can help investors to generate comprehensive results regarding their investment selection. From a theoretical point of view the mean variance framework can be helpful for the portfolio structuring of a mixed asset portfolio. On the other hand the illustrated practical techniques (DCF, IRR, etc.) are widely used tools for the evaluation of single projects in the real estate sector. Further advanced quantitative techniques such as resampling and downside risks optimization are applicable for the real estate sector and they are increasingly applied. Still it is questionable if these models can explain the whole investment decision. A survey of UK decision makers was undertaken.
First of all the general research question can be summarised the following way:
What are the most relevant decision criteria/techniques for real estate investors in the UK and did their real estate investment decision approach changed in recent years?
There are several reasons why this particular research question has been formed. First of all it is very interesting to further examine what factors have a strong influence on a real estate investment decision. French (2001) also indicated that there is a need to further analyse the relatively opaque process of real estate decision making. As already outlined, many studies suggest a strong influence of intuitive decision behaviour, so that it would be worthwhile to analyse if this is still the case. Later studies such as Roberts and Henneberry (2007) suggest that the investment decision practice has been modified only rarely in the last decades. In respect of Farragher and Savage’s work (2008) it should be evaluated if the search phase (or a similar step) of the decision making process is still considered as most important. Their study indicated that the phase of the property search (dealing phase) was considered as most important by investors. Other studies such as Worzala (1997) and Gallimore et al. (2000) indicated that investors rarely apply advanced quantitative models. Hence, it is questionable if this fact has changed through the financial crisis.
The main reason why the UK market was chosen lies in the reason that the UK is one of the most transparent and mature real estate markets, as the Jones Lang LaSalle Global Real Estate Transparency Index 2010 displays. Another advantage of this market is that it is familiar and easily accessible for the author.
None of the previously analysed studies questioned a future trend of the asset allocation framework of investors. Most of the survey literature focused on market sentiment (French, Gallimore and Gray), the decision process (Roberts and Henneberry, Farragher and Savage) and general decision criteria of real estate investments. The survey seeks to be a relevant supplement of these studies that will offer additional insights to the latest developments of investment decision making.
The most important research questions are as follows:One important innovation of the survey is that it questions the relevant decision model at the stage of the dealing phase (analysing phase). Hence, the results should give answers as to which practical considerations are most important during this decision phase.
As mentioned earlier the survey received through the method of telephone interviews a response of 16 interviews from an initial sample of 78 investors, which represents a response rate of 21.8 per cent. The literature suggests that this result is a good average (Gallimore et al., 2000).
The survey is divided into the following three issues: general questions, decision making process and decision making in the economic cycles and the future.
Most of the respondents were “fund managers” of private investment companies. The average work experience of the respondents was between five and ten years. The average size of a portfolio (mixed assets and real estate (RE)) was above £3 billion, with an average real estate portfolio of £2.933 million. The strongest proportion of the asset allocation regarding property type was the retail sector (with 36 per cent).
Decision making process and investment decision criteria
The survey asked about the importance of each decision stage. Hence, a typical investment decision process was presented to the respondents.
On the subject of the general ranking, some respondents indicated the following: “It is very hard to rank these stages, since they are interlinked they can’t be pursued without the examination of the previous stage”.
Nonetheless, the respondents on average ranked the “dealing phase” as most important. They indicated that the search and analysis of potential investment properties is, from their point of view, the most important stage. In contrast the “planning phase” was ranked as least important. Most of respondents mentioned that they generally do not take too much time for the planning phase, since this phase should just further outline the definition phase.
With regard to the definition phase all respondents answered that they have certain objectives to define which are generally related to the risk/return and other standards.
The next question asked the respondents about the most important decision technique and criteria in the dealing phase. The respondents had the option to choose between more quantitative or qualitative models and were able to indicate one from each type. Nearly, all respondents chose to pick both criteria (14 out of 16) with only two candidates picking from only one criterion. As Figure 2 indicates most of the respondents used practical techniques (DCF, IRR, etc.) as a quantitative model (81.25 per cent). On the other hand the most important qualitative criteria were the property specifics (62.5 per cent) and the general experience (25 per cent). Important to highlight is that only one Investment Analyst selected the MPT. Several fund managers indicated that they know of these theories but they do not make any use of either MPT or CAPM.
Future trends and the economic climate
The initial questions covered the issue of decision making with reference to the economic climate and future trends. The later questions asked the respondents about their expectations as to which model will become more important in the near future (five years). Many fund managers outlined that sensitivity analysis and risk models will receive more importance. Most of them noted that the both are combined. Many participants mentioned that they are generally happy with their risk assessment tools, but they are still seeking to expand and improve these models.
The next question asked the respondents if the proportion of real estate they manage has dramatically changed through the onset of the economic crisis. At this point it is worth mentioning that the question only makes sense for respondents who have a mixed asset portfolio. However, by just looking at the respondents who meet this criteria, most of them indicated that the proportion did not dramatically change. This question was aiming to identify if real estate could be seen as a relatively secure investment compared to equity stocks. Since the result is not strongly angled in either direction, it can be concluded that most of the portfolios did not experience a dramatic decrease in the real estate proportion.
In this context, many participants outlined thoughts similar to this:
Certainly the value of the real estate assets and the whole fund narrowed, nonetheless through cash holdings and other measurements we were generally able to hold our real estate assets.
Another question asked the sample group if there was any decision model (quantitative of qualitative), which played the major role during the economic boom. Most of the investors (12 out of 16) indicated that they made more use of qualitative models, especially their general experience, during this time. On the other hand some respondents (three people) highlighted that they used a combination of quantitative and qualitative models. One life fund manager said the following:
As mentioned both models are relevant, however nowadays greater risk analysis and stress test might be more important.
In contrast two fund managers emphasised the importance of practical techniques (DCF, etc.) and the general experience (qualitative). They indicated that through troubled times, general experience will be a key characteristic to generate stable returns.
Finally, the participants were asked if their views have changed through the appearance of the economic crisis. The result shows that most of the respondents have changed their view (11 people vs five). This result in combination with the prior questions emphasises the idea that risk assessment tools and other quantitative techniques have become more relevant. Before conducting the survey it was questionable whether real estate investors have changed their decision models from a more intuitive way (qualitative models) to more quantifiable models (quantitative models). However, this implication could be partially confirmed which does not however mean that the general experience does not continue to have a high importance in the investment process. Nonetheless, the result indicates that investors are still highly reliant on their general experience but make stronger use of advanced risk assessment methods which, when taken in combination, could be seen as an advancement.
This survey was seeking to garner some recent insights into the decision making practice of high value UK real estate investors. The sample included all major London based investment companies with an average real estate value of above £3 billion. The respondents were all highly qualified with an average professional experience of between five and ten years. Generally all the real estate portfolios had a focus on retail properties.
Regarding the decision making process the survey highlights that the dealing phase (analysing phase) is the most important decision phase. On this subject the respondents highlighted that both the practical techniques and property specifics play a major role. In the overall decision process the practical techniques, the general experience and benchmarking are seen as the most relevant for an investment decision. It is a matter of some note that only one investment analyst highlighted the relevance of the MPT theory as a decision model. Nonetheless, most of the respondents indicated that sensitivity analysis will be one of the most important tools for the future. Also most the respondents indicated they are going to expand their risk assessment. During the economic boom most investors favoured qualitative criteria, in particular general experience, as the most important decision model. Nowadays this view has changed since most of the fund managers indicated a stronger focus on risk models and quantifiable values which does not necessarily have to imply the exclusion of the general experience.
This research gives further insights into the investment decision making process of real estate investors. The work explained the DM process in general and in context to real estate. Further on the thesis examined various normative models that can support the investment decision. Theories like the MPT give a good background for professional portfolio management, but techniques such as DCF, IRR, down side risk minimization and resampling are much more applicable for the real estate sector.
The empirical survey gives the latest insights into the development of the DM context of UK investors. Hence, it must be stressed that the general experience and practical techniques are still most important for the DM process. Investors also evaluated the analysing phase (dealing phase) as the most important decision phase. Although the MPT is rarely applied in practice, most investors highlighted their advancement in quantitative techniques, especially the sensitivity analysis and downside risk models. In contrast to the given assumption of the literature the practice has advanced in some way. Obviously most investors revaluated their decision models and nowadays they have stricter and more tangible standards (in context to risks, etc).
1. UK achieved the third rank in the JLL Global Real Estate Transparency Index 2010.
Abbreviations: RQ1. What investment decision models are most relevant for real estate decision making?; RQ2. Has the use of decision models changed in the recent years?; RQ3. Have the applied decision models changed either during or after the financial crisis?; RQ4. During a typical real estate investment decision process, which stage can be seen as most relevant?; RQ5. Which decision models will become more important in the near future?
The author would like to especially thank his supervisors Claire Roberts and Nick French. Without their advice and their professional network this work would not have such an empirical value. The author would also like to thank his parents for their tremendous support during his studies.
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