1

Valuation of Properties and Economic

Models of Real Estate Markets

Rainer Schulz

CASE Center for Applied Statistics and Economics

Institut f
ur Statistik und Okonometrie
SFB 373
Humboldt-Universitat zu Berlin

Real Estate Valuation

Introduction and motivation 1-1

Introduction and motivation

Real estate valuation is important at the micro level for
investment decisions like buying or selling a property,
lending decisions where a property serves as collateral.
Real estate valuation is also important at the macro level for
measurement of real estate price trends via appraisal based indices
like the NCREIF or the DIX,
measurement of real estate wealth.

Real Estate Valuation

Introduction and motivation 1-2

What is property valuation?

Valuation is the process of estimating the market value of a property.
Valuation consists of physical and legal identification of property
(rights), gathering and analyzing of market data, and applying the
convenient valuation approach.
Major valuation approaches:
sales comparison approach
cost approach
income approach

Real Estate Valuation

Introduction and motivation 1-3

A valuation approach is based on an economic market model and may

have different techniques to calculate indicated values.

Indicated value = VA(xn,t , t ) (1)

xn,t vector with characteristics of the property

t set with market information
Adjustment for general market conditions gives
a
Vn,t = Mt VA(xn,t , t ) (2)

a
Vn,t ascertained market value
Mt general market conditions

Real Estate Valuation

Introduction and motivation 1-4

Focus: income valuation in Germany

codified valuation technique, specified in Regulation on Valuation
(WertV) and Guidelines on Valuation (WertR 91),
enhancing the economic understanding of the valuation approach,
assessment of the appraisals compared with transaction prices,
influence of characteristics and market indicators,
results are of interest for the discussion on valuation approaches, see
RICS (2002); IVSC (2002); Dotzour (1988); Chinloy, Cho, and
Megbolugbe (1997); Graff and Young (1999); Crosby (2000)

Real Estate Valuation

Income approach according to WertV 2-1

Economic rationale of the income approach

No investor will pay more for an existing property than he will retrieve by
holding the property.
Market value is the present value (Cochrane, 2001)


X Dn,t+j
Vn,t = Et Qj (3)
j=1 i=1 (1 + Rt+i )

def
Et [] = E[|xn,t , t ]
Dn,t+j net operating rent
Rt+i required returns from comparable investments

Real Estate Valuation

Income approach according to WertV 2-2

WertV valuation technique

Income value (Ertragswert) according to 15, 16 WertV is

  n,t   n,t
1 1 1
En,t = 1 Dn,t + Ln,t (4)
t 1 + t 1 + t

n,t remaining time of usage

t discount rate (Liegenschaftszins)
Dn,t net operating rent
Ln,t approximate value of the lot

Real Estate Valuation

Income approach according to WertV 2-3

Adjustment of En,t gives

a
Vn,t = Mt En,t (5)

General market conditions Mt reflect the current situation on the real

estate market, the capital market and the regional situation.
3 Abs. 3 WertV and 1.5.3 WertR 91 imply that

E[Mt ] = 1 . (6)

Real Estate Valuation

Income approach according to WertV 2-4

Statistical model
Transaction price is market value influenced by proportional unusual
circumstances
Pn,t = Vn,t Un,t
with Et [Un,t ] = 1. With
Vn,t = Mt En,t
def Pn,t
Qn,t =
En,t
one obtains
Qn,t = Mt Un,t . (7)

Real Estate Valuation

Income approach according to WertV 2-5

Implications from the statistical model

1. long-run: expected deviations between Pn,t and En,t disappear

E[Qn,t ] = 1 ,

i.e. income valuation according to WertV is unbiased.

2. short-run: expected deviations between Pn,t and En,t are

Et [Qn,t ] = Mt ,

i.e. all property specific information has to be incorporated in En,t .

Real Estate Valuation

Empirical investigation 3-1

Empirical investigation
Data are provided by the Gutachterausschuss f
ur Grundst
uckswerte in
Berlin
transaction prices and property characteristics of apartment houses
in Berlin between 1980:1 and 2000:5, 4150 observations
indicated values are income values (Ertragswerte) calculated
according to WertV for internal purposes
Data are stored in the non-public sector of MD*Base, www.mdtech.de.

Real Estate Valuation

Empirical investigation 3-2

Table 1: Summary statistics for transacted apartment houses in Berlin,

Germany between 1980:1 to 2000:5.

Mean Median Std. Dev. Min Max Units

Lot size 982.2 767.0 1920.8 186.0 56332.0 Square metres
Floor space 2168.9 1867.5 2637.2 128.0 89614.0 Square metres
Age 73.9 81 29.2 0 186 Years
Price 721.2 496.0 1120.9 53.7 40900.0 Thsd. EUR
Income value 662.2 455.6 1451.8 48.1 72800.0 Thsd. EUR
Gross rent 54.8 43.3 90.0 6.2 4260.5 Thsd. EUR
Net rent 61.9 33.6 131.0 3.6 1610.7 Thsd. EUR
Note: 3835 observations have information on the gross rent and 315 on the net rent.

Real Estate Valuation

Empirical investigation 3-3

25.00
finely dashed: all objects built before 1949
dashed: all objects built after 1948
22.50 solid: all objects

20.00

17.50

15.00

12.50

10.00

1980 1985 1990 1995 2000

Figure 1: Average yearly price-rent ratios from 1980 to 2000. Calcu-

lated with all 3835 observations with information on gross rents.
REVincome1.xpl

Real Estate Valuation

Empirical investigation 3-4

Table 2: Summary statistics for ratios of prices and income values.

Panel A: Ratios of Price to Income Value

Mean Standard deviation Minimum Median Maximum
1.133 0.392 0.247 1.058 4.941
10% Quantile 90% Quantile Skewness Kurtosis Number of obs.
0.773 1.577 2.726 19.178 4150
Panel B: Ratios of Income Value to Price
Mean Standard deviation Minimum Median Maximum
0.968 0.294 0.202 0.945 4.044
10% Quantile 90% Quantile Skewness Kurtosis Observations
0.634 1.294 1.562 12.147 4150

REVincome2.xpl

Real Estate Valuation

Empirical investigation 3-5

Result I
Income values according to WertV are biased predictors for prices in the
long run
reject hypothesis E[Q] = 1 with

N (Q 1)
= 21.8
sQ

reject hypothesis E[1/Q] = 1 with

N (1/Q 1)
= 7.06 .
s1/Q

Income values understate transaction prices on average.

Real Estate Valuation

Empirical investigation 3-6

Recall income value according to WertV is

  n,t   n,t
1 1 1
En,t = 1 Dn,t + Ln,t
t 1 + t 1 + t

(Complementary) explanations for understatement of prices:

discount rates t are too large on average
assessed net operating rents Dn,t are too low on average
approximate lot values Ln,t are too low on average
remaining times of usage n,t are too low on average

Real Estate Valuation

Empirical investigation 3-7

Table 3: Linear regression for q on object-specific characteristics.

Coefficient t-Statistic P-Value

Log real gross rent 0.034 2.89 0.004
Log lot size -0.027 -2.01 0.045
Age -0.001 -4.89 0.000
Diagnostics
R2 0.218 2
R 0.166
F-Statistic 4.197 P-Value(F-Stat.) 0.000
Observations 3835 c2
0.069
Notes: Coefficients for overall constant and time dummies are not reported. Gross
rents are deflated with StaLa consumer price index for households comprising four
persons with average income in Berlin West, base year is 1995.

REVincome3.xpl

Real Estate Valuation

Empirical investigation 3-8

Capitalization technique
Multiple technique (Maklermethode) simply capitalizes current gross
g
rent Dn,t (Gottschalk, 1999)
g
a
Dn,t
Vn,t = g (8)

g is derived from comparable sales.

We calculate g s for all 3835 properties with information on gross rents,
so that
average ratio of price to capitalized income value is one, P M
average ratio of capitalized income value to price is one, M P

Real Estate Valuation

Empirical investigation 3-9

Table 4: Comparison of income valuations according to WertV and

multiple technique.

Panel A: Variance Bias MSPE

WertV price to income value 0.129 0.135 0.147
P M price to income value 0.167 0 0.167
WertV income value to price 0.079 -0.042 0.080
M P income value to price 0.126 0 0.126
Panel B: MAPE Percentage within 15%
WertV price to income value 25.72% 44.64%
P M price to income value 29.56% 31.94%
WertV income value to price 21.17% 45.35%
M P income value to price 27.80% 32.46%

REVincome4.xpl

Real Estate Valuation

Empirical investigation 3 - 10

Recognize that the economic loss associated with a forecast may be

poorly assessed by the usual statistical metrics (Diebold and Mariano,
1995)
Example: unbiased valuation approach that exhibit large positive outliers
might be inferior for lending purposes compared with a biased, but
conservative valuation approach (Shiller and Weiss, 1999).
Investors are interested in valuation approach that minimizes their loss
function.

Real Estate Valuation

Empirical investigation 3 - 11

1.75
ratios of price to income value, multiple technique
ratios of price to income value, WertV
1.50

1.25

1.00

0.75

0.50

0.25

0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50

Figure 2: Nonparametric density estimates for ratios of price to income

value. Uniform confidence bands are at the 95% level (M uller, 2000).
REVincome5.xpl

Real Estate Valuation

Empirical investigation 3 - 12

1.75 ratios of income value to price, multiple technique

ratios of income value to price, WertV
1.50

1.25

1.00

0.75

0.50

0.25

0.50 1.00 1.50 2.00 2.50 3.00 3.50

Figure 3: Nonparametric density estimates for ratios of income value

to price. Uniform confidence bands are at the 95% level.
REVincome6.xpl

Real Estate Valuation

Empirical investigation 3 - 13

Result II
Multiple technique is a simpler technique than income valuation
according to WertV.
Regarding MSPE and MAPE, outcomes from multiple technique are
inferior compared with the outcomes from the WertV technique.
Density estimates reveal that investors and lenders may generally prefer
income valuations according to WertV if
conservative valuation is associated with smaller loss
loss increases with size of absolute prediction errors

Real Estate Valuation

Empirical investigation 3 - 14

General market conditions

Valuation according to WertV is a two step procedure.
Second step is adjustment of En,t with market conditions Mt .
Mt is influenced by ( 3 WertV, GAA reports)
five-year mortgage rates
interest rates for credits
building permissions
inflation
market volume

Real Estate Valuation

Empirical investigation 3 - 15

Rationale for Mt
Ascertained market value is
a
Vn,t = Mt En,t

and market value is

X Dn,t+j
Vn,t = Et Qj .
j=1 i=1 (1 + Rt+i )

Income value is calculated with constant discount factor.

Thus, Mt may account for time-varying discount rates.

Real Estate Valuation

Empirical investigation 3 - 16

Approximation of the market value (Campbell, Lo, and MacKinlay, 1997;

Cochrane, 2001)

X
log Vn,t j {k + (1 )Et [dn,t+1+j ] Et [rt+1+j ]} , (9)
j=0

where
def
dn,t = ln Dn,t
def
rt+j = ln (1 + Rt+j )
k and are approximation constants
0<<1

Real Estate Valuation

Empirical investigation 3 - 17

En,t is market value ascertained with constant discount factor r.

Thus

X
qn,t = j Et [rt+1+j r] + n,t (10)
j=0

and

def
X
mt = j Et [rt+1+j r] (11)
j=0

gives
qn,t = mt + n,t . (12)
mt accounts for time-varying discount rates.

Real Estate Valuation

Empirical investigation 3 - 18

Expected return deviations will be influenced by market indicators

+ s>
(L)mt = t + t (13a)

and
qn,t = mt + n,t . (13b)

(L) = 1 1 L 2 L2 . . . p Lp and Lj xt = xtj

st is a vector that collects the market indicators
are coefficients of the indicators
The above system represents a state space model (SSM).

Real Estate Valuation

Empirical investigation 3 - 19

Table 5: Estimated SSM for the general market conditions for 1982:6
to 2000:5.
Coefficient t-Statistic P-Value
0.925 32.26 0.000
-0.689 -6.07 0.000
[
ln -2.892 -20.56 0.000
[
ln -1.265 -104.87 0.000
Spread5 -3.953 -2.90 0.004
Real interest 5.759 1.68 0.092
Building permissions -0.027 -1.55 0.121
Log number of transactions 0.015 2.52 0.012
Rent index -0.986 -0.94 0.349
continued on the next slide

Real Estate Valuation

Empirical investigation 3 - 20

Table 5: continued

Coefficient t-Statistic P-Value

0.168 2.44 0.015
Log lot size -0.015 -1.66 0.097
Age -0.001 -2.67 0.008
Diagnostics
Log likelihood 2720.192 c2
0.080
Observations 3629 cq2
0.096

Real Estate Valuation

Empirical investigation 3 - 21

0.50

0.25

0.00

-0.25

-0.50

1985:1 1990:1 1995:1 2000:1

Figure 4: Smoothed general market conditions 1982:6-2000:5. Confi-

dence bands are at the 95% level.
REVincome7.xpl

Real Estate Valuation

Conclusion 4-1

Conclusion
Present value is economic rationale of income valuation according to
WertV.
Two step valuation technique with constant discount rate, second step
adjusts for short-run variations of the discount rate.
Outcomes are biased, but better than outcomes from the simpler
multiple technique according to MAPE and MSPE.
Ranking of valuation techniques depends on whole distribution of
outcomes and loss function of investors.

Real Estate Valuation

Conclusion 4-2

General market conditions account for about 17% in systematic variation

of valuation ratios.
Explanatory factors for general market conditions are sensible and should
be included systematically into the valuation process.
Tax treatment of real estate investments is neglected in the economic
model and the valuation process.

Real Estate Valuation

References 5-1

References
Campbell, J. Y., A. W. Lo, and A. C. MacKinlay (1997): The
Econometrics of Financial Markets. Princeton University Press,
Princeton, New Jersey.

Chinloy, P., M. Cho, and I. F. Megbolugbe (1997):

Appraisals, Transaction Incentives, and Smoothing, Journal of Real
Estate Finance and Economics, 14:12, 89111.

Cochrane, J. H. (2001): Asset Pricing. Princeton University Press,

Princeton, New Jersey.

Crosby, N. (2000): Valuation Accuracy, Variation and Bias in the

Context of Standards and Expectations, Journal of Property
Investment & Finance, 18, 130161.

Real Estate Valuation

References 5-2

Diebold, F. X., and R. S. Mariano (1995): Comparing Predictive

Accuracy, Journal of Business & Economic Statistics, 13, 253263.

Dotzour, M. G. (1988): Quantifying Estimation Bias in Residential

Appraisal, Journal of Real Estate Research, 3(3), 111.

Gottschalk, G.-J. (1999): Immobilienwertermittlung. C.H. Beck,

Munchen.

Graff, R. A., and M. S. Young (1999): The Magnitude of

Random Appraisal Error in Commercial Real Estate Valuation,
Journal of Real Estate Research, 17(1-2), 3354.

IVSC (2002): Exposure Draft of Proposed International Valuation

ApplicationMass Appraisal of Real Property, International
Valuation Standards Committee (IVSC), London, www.ivsc.org.

Real Estate Valuation

References 5-3

ller, M. (2000): Smoothing Methods, in XploRe Learning

Mu
Guide, ed. by W. Hardle, S. Klinke, and M. M
uller, pp. 169204.
Springer-Verlag, Berlin.

RICS (2002): Property Valuation: The Carsberg Report, Royal

Institution of Chartered Surveyors, www.rics.org.uk.

Shiller, R. J., and A. N. Weiss (1999): Evaluating Real Estate

Valuation Systems, Journal of Real Estate Finance and Economics,
18:2, 147161.

Real Estate Valuation