IPD Technical Note

Methodology changes to the

PCA/IPD Australia Property Index

IPD Australia
August 2009
IPD Technical Note
Methodology changes to the PCA/IPD Australian
Property Index

The aim of the PCA/IPD Australia Property Index is to provide a clear and accurate
representation of the returns in the Australian property market, enabling a credible
comparison of property with other asset classes, and allowing comparison of different parts of
the property market.

The methodological changes introduced with the publication of the June 2009 index on 18
August 2009, and the restated index history that accompanied it, represent a significant
improvement in the index’s ability to meet those key objectives. The changes also mean that
Australian index is now more directly comparable with the other markets that are covered by
IPD around the world.

The chart above shows the impact of the restatement of the total returns in the PCA/IPD
Australia Property Index at an all property level to March 2009.

Why was it necessary to change?

All property indices tend to lag the underlying markets they seek to report. This is because
they rely on valuation evidence based on comparable transactions and it takes time for this
information to be absorbed by appraisers. More frequent appraisal of the assets going into the
index is the best way of minimising this, but lags of this sort can never be entirely eliminated.

However, the PCA/IPD Index has historically included a methodological lag in addition to the
valuation lag. In rising markets it has tended to understate the returns generated by the
market, and in sharply declining markets, such as the one we have experienced recently, it
has tended to overstate the true level of returns.

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 IPD Technical Note
Methodology changes to the PCA/IPD Australian
Property Index

The problem is caused by the absence of real estate valuations for all assets within the
databank at each point the index is published, and the assumptions made about the value of
the assets that are not refreshed with a new valuation.

It is a feature of the Australian property market that property valuations are not synchronised.
That is, they do not all occur in a common month or quarter end for every property. Valuations
of different properties in a fund are often spread through the year. This means that there is no
one point in any year at which all assets in the database have an up-to-date valuation and
can be compared on a strictly like-for-like basis. The table below shows the size of the IPD
database over the past two years and the percentage of properties that were valued in each
quarter. More valuations are undertaken in December and June than March and September.
The proportion of properties valued recently has risen in recently quarters, but still only 13%
of properties are revalued every quarter.

Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09

Number of
1,318 1,306 1,327 1,316 1,306 1,260 1,248 1,187
investments
Capital Value
100.5 100.7 106.4 108.4 108.8 104.9 98.4 95.7
(AU$ bn)
Percentage
60.9 28.4 62.2 29.1 59.8 25.0 78.4 34.6
revalued (%)

The methodology that was used by IPD up to March 2009, and previously applied by the
Property Council before 2005, held the value of a property flat until until there was a new
valuation, then took the whole of the uplift (or fall in value) in the final month. Values were
often held flat for a year, and occasionally longer. The result was that in each reporting period
there was a significant proportion of the assets in the databank that were not refreshed and
therefore contributed 0% capital growth to the returns of their respective sectors. The greater
the proportion of the database that is unvalued, the greater the degree of inertia in the index
returns.

The new methodology makes better use of all of the valuations and information currently
supplied to IPD by minimising the dilution from data relating to earlier points in time. This is
achieved by ensuring that intervening values between appraisals take account of market
movement, rather than assuming zero movement, by use of linear interpolation and the
temporary exclusion of properties that have not been revalued. The method described in
detail below.

Benefits of the new method

• Reduction of lags. The new methodology significantly reduces the methodological lag
associated with infrequent valuations. By more accurately reflecting progression of value

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IPD Technical Note
Methodology changes to the PCA/IPD Australian
Property Index

at each point in time, the understatement of returns in a rising market or overstatement

of returns in a falling market is reduced.

Of course, the best way to improve the accuracy of a property index is to increase the
frequency of property valuations contributing to the index. Some fund managers have
undertaken more frequent valuations during the current market downturn, and we hope
this trend will continue once values start to stabilise.

• More accurate turning points. The clear and timely representation of turning points in the
market is of key importance to all index users. A more accurate picture of the turning
points at the start of the current downturn is one of the benefits of the new methodology.
The lag inherent in the old methodology is one of the reasons why the Australian index
turned negative later than some other countries.

Peak Capital Returns Negative Capital Returns Capital Return (Dec 08)
(pa) (pa) (% pa)
New Old New Old New Old
Retail Dec 06 Dec 06 Sep 08 Dec 08 -6.0 -5.2
Office Sep 07 Mar 08 Sep 08 Dec 08 -6.4 -3.9
Industrial Sep 07 Dec 07 Sep 08 Dec 08 -9.0 -7.5
All Property Sep 07 Dec 07 Sep 08 Dec 08 -6.4 -4.8

• Greater comparability of sectors, properties and funds. With the new methodology, it is
much less likely that differences in performance can simply be dismissed as due to
differences in the timing of valuations.

The total return formula is not affected

IPD employs the same formula for calculating returns all around the world, and this is not
affected by the changes that have been introduced.

IPD’s time-weighted performance methodology is underpinned by monthly cashflows. Total

returns, capital growth and income returns are calculated on a monthly basis and chain-linked
(compounded) to derive annual rates. Capital values are needed for each month in both the
numerator and denominator of the formula used to calculate the return on capital employed,
so the assumptions used in determining the capital value inputs are important.

With respect to a single month total return is defined as:

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IPD Technical Note
Methodology changes to the PCA/IPD Australian
Property Index

Where:
TRt is the total return in month t;
CVt is the capital value at the end of month t;
CExpt is the total capital expenditure (includes purchases and developments) in month t;
CRptt is the total capital receipts (includes sales) in month t;
NIt is the day-dated rent receivable during month t, net of property management costs,
ground rent and other irrecoverable expenditure.

What is the impact of the change?

Over the full history of the index there is remarkably little difference between the market
returns on the old and new methodologies. There is just six basis points difference in the
annualised return over the full history of the index between December 1984 and December
2008.

However in many individual years, the differences are much more substantial, due to the
differences in timing between the indices and the way the new methodology generally
succeeds in capturing the turning points in the market sooner. The average lag between the
old index methodology and the new methodology is +/- 1.3 percentage points per annum.

Long term return (% pa) Average lag Standard

Dec 84 to Dec 08 (pp per annum) deviation of lag
New Old
All Property 10.58 10.65 1.3 1.3
Retail 13.33 13.19 1.3 1.4
Office 9.18 9.17 1.7 1.5
Industrial 11.76 11.47 1.6 1.5

The difference between the two methodologies is greatest in sub-sectors with a small number
of assets, where the performance of individual assets and the historic pattern of their
revaluation can have a bigger influence. When they are investigated, many of the differences
turn out to be due to assets (or groups of assets in a single ownership) being revalued after a
prolonged period. All the change in value comes at once in the old methodology, which
causes a spike in returns, whereas in the new methodology the change is spread over the
intervening period between the valuations.

Other features of the new index methodology

An important feature of the new methodology, which was not present in the old, is a degree of
systematic restatement of the index each quarter up to the point it is no longer based on
partial data. However, the index has always been subject to a degree of retrospective
restatement in the light of new or corrected data, so there is not a significant change in
practice.

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IPD Technical Note
Methodology changes to the PCA/IPD Australian
Property Index

The method of interpolation is explained in detail in the technical appendix. However, it is not
possible to calculate the intervening capital values for an asset until there are two valuation
points to move between. So for a property valued in December and June, it will not be
possible to calculate values for January through to May until the valuation in June is known.
The property’s value is held flat in the databank until the new valuation is known, but these
values are excluded from the calculation of the index. The property in our example would be
included in the index return for the December quarter, but would not be included in the
calculation of the March index. The property would then be reinstated in the June index and
the values that were held flat in the databank would be overwritten with interpolated values.
At the same time, the March return will be restated to include the property that had previously
been excluded.

The proportion of assets with an actual or interpolated value increases with each restatement,
and this percentage of assets backed by valuation evidence is shown for each quarter in the
table in the index publication. Once the full sample has been valued, the index will stabilise
and will no longer be subject to restatement. In practical terms, larger restatements might be
expected in respect of the March and September quarters, which see a smaller proportion of
assets appraised. The scale of restatement will be linked in part to the volatility of the market,
but each restatement gets closer to the true market performance.

To avoid distortions due to the differential valuation of retail, office and industrial properties in
different quarters, and consequential changes in sector weights, the All Property return is mix-
adjusted for the most recent quarters. This ensures the index reflects the weights of the full
databank using each property’s last known value. Mix adjustment is a temporary measure,
affecting only the most recent quarters, which have incomplete samples. Once every property
has been revalued, a full sample is achieved and it is no longer a feature.

Contact details
Should you wish to discuss the methodology of the PCA/IPD Index further please contact
either:
Jess Moyer Anthony de Francesco
Research Managing Director
jess.moyer@ipd.com anthony.de.francesco@ipd.com
+61 (0)2 9248 1900 +61 (0)2 9248 1901

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IPD Technical Note
Methodology changes to the PCA/IPD Australian
Property Index

Technical appendix - Old and new methodologies compared

Old methodology - based on values held flat

The IPD total return formula requires a capital value at the start and end of every month. For
most properties in most countries, actual valuations are not available at this frequency. It is
therefore necessary to populate the database with estimated values for the months between
actual valuations to drive the formula. In Australia, IPD continued to use the methodology
previously employed by PCA until March 2009. This took the previous known capital value
and adjusted for capital expenditure or receipts apportioned during the period using the
process:

Where CV, CExp and CRpt have the same meanings as in the earlier equation.

The Capital Return for the asset is therefore zero for all months except for when a valuation
occurred. This introduces an inertial tendency into published results, as a new valuation must
occur before any capital change is recorded.

Example 1.1 – old method without capital expenditure

Take a simple example of a property that has no capital expenditure and is valued at $100m
in December 2007 and $120m in December 2008. Under the old methodology the capital
value would remain $100m in each month up until the valuation in December 2008 when it
jumps to $120m due to the valuation. The entire year’s capital growth is recorded in the
month of December 2008.

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IPD Technical Note
Methodology changes to the PCA/IPD Australian
Property Index

Valuation Capital Capital value Capital

($m) expenditure ($m) recorded ($m) growth %pm
Dec-07 100 0.0 100 -
Jan-08 0.0 100 0.0
Feb-08 0.0 100 0.0
Mar-08 0.0 100 0.0
Apr-08 0.0 100 0.0
May-08 0.0 100 0.0
Jun-08 0.0 100 0.0
Jul-08 0.0 100 0.0
Aug-08 0.0 100 0.0
Sep-08 0.0 100 0.0
Oct-08 0.0 100 0.0
Nov-08 0.0 100 0.0
Dec-08 120 0.0 120 20.0

Example 1.2 – old method with capital expenditure

Using the same property as used in Example 1.1, valued at $100m in December 2007 and
$120m in December 2008, but this time with $6m of capital expenditure reported in the June
quarter. Firstly, the expenditure is apportioned evenly over the quarter – so $2m in each of
April, May and June. The capital values are adjusted according to Equation 2, and the capital
growth remains zero in all months except December 2008 when the valuation occurs.

Valuation Capital Capital value Capital

($m) expenditure ($m) recorded ($m) growth %pm
Dec-07 100 0.0 100
Jan-08 0.0 100 0.0
Feb-08 0.0 100 0.0
Mar-08 0.0 100 0.0
Apr-08 2.0 102 0.0
May-08 2.0 104 0.0
Jun-08 2.0 106 0.0
Jul-08 0.0 106 0.0
Aug-08 0.0 106 0.0
Sep-08 0.0 106 0.0
Oct-08 0.0 106 0.0
Nov-08 0.0 106 0.0
Dec-08 120 0.0 120 13.2

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IPD Technical Note
Methodology changes to the PCA/IPD Australian
Property Index

New methodology – Based on interpolated values

In the new method introduced for the Q209 index, IPD in Australia has moved to the system
used in its other databanks around the world for populating missing capital values in non-
valuation months. The standard method of estimation is a straight line interpolation between
two actual valuations to give values for intervening months.

In reality, properties are constantly changing in value and the uplift (or fall in value) is not all
concentrated in a single month. The new methodology recognises this by apportioning the
changing in value between two valuations throughout the entire period.

The true pattern of growth between two valuations is, of course, unknown. However, in the
absence of other information, a constant progression between the two known observations is
the most neutral assumption it is possible to make. The more frequently a property is
appraised, the less reliant we are on the assumptions we make about the pattern of growth.

Intervening capital values are calculated by dividing the difference between the two valuations
by the valuation interval (number of months) and adding this amount to the previous month’s
value. When capital expenditure is added the effect is to create an uplift in value equal to the
expenditure amount at the point it is incurred and the valuation uplift is prorated according to
the capital employed in each month. This methodology effectively apportions the capital
growth of an asset between two valuations over the entire period, rather than allocating all of
the growth into the month of valuation. It is the most neutral assumption possible about the
pattern of growth between two valuation points.

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IPD Technical Note
Methodology changes to the PCA/IPD Australian
Property Index

Example 2.1 – new method without capital expenditure

As in the previous examples, consider a property valued at $100m in December 2007 and
$120m in December 2008, with no capital expenditure in the first instance. The total uplift in
value between the two valuations is $120m - $100m = $20m. This amount is apportioned over
the 12 months, which gives a $20m / 12 = $1.7m uplift in each month. These amounts are
added cumulatively to the starting value as shown in the table below.

Valuation Capital Capital value Capital

($m) expenditure ($m) recorded ($m) growth %pm
Dec-07 100 0.0 100.0
Jan-08 0.0 101.7 1.7
Feb-08 0.0 103.3 1.6
Mar-08 0.0 105.0 1.6
Apr-08 0.0 106.7 1.6
May-08 0.0 108.3 1.6
Jun-08 0.0 110.0 1.5
Jul-08 0.0 111.7 1.5
Aug-08 0.0 113.3 1.5
Sep-08 0.0 115.0 1.5
Oct-08 0.0 116.7 1.4
Nov-08 0.0 118.3 1.4
Dec-08 120 0.0 120.0 1.4

Example 2.2 – new method with capital expenditure

The previous example was based on a property with no capital expenditure during the year. If
we add in $6m expenditure in the June quarter the capital values will need to be adjusted
accordingly. The first step will be to add $2m of capital expenditure to the capital value in
each of April, May and June. In this situation, the total uplift due to valuation increase is

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 IPD Technical Note
Methodology changes to the PCA/IPD Australian
Property Index

$120m - $100m - $6m = $14m. This profit is then prorated across the 12 months between
valuations according to the capital value plus cumulated expenditure in each month. The
calculated values for each month are shown below. The capital value recorded is the sum of
start value + cumulated expenditure + cumulated profit.

Valuation Capital Start value + Prorated Cumulated Capital Profit / Capital

($m) expenditure cumulated profit profit $m value Start value growth
($m) expenditure $m recorded + cum %pm
($m) ($m) expend %
Dec-07 100 0.0 100.0 100.0
Jan-08 0.0 100.0 1.12 1.12 101.1 1.12 1.1
Feb-08 0.0 100.0 1.12 2.24 102.2 1.12 1.1
Mar-08 0.0 100.0 1.12 3.37 103.4 1.12 1.1
Apr-08 2.0 102.0 1.14 4.51 106.5 1.12 1.1
May-08 2.0 104.0 1.17 5.68 109.7 1.12 1.1
Jun-08 2.0 106.0 1.19 6.87 112.9 1.12 1.1
Jul-08 0.0 106.0 1.19 8.05 114.1 1.12 1.1
Aug-08 0.0 106.0 1.19 9.24 115.2 1.12 1.0
Sep-08 0.0 106.0 1.19 10.43 116.4 1.12 1.0
Oct-08 0.0 106.0 1.19 11.62 117.6 1.12 1.0
Nov-08 0.0 106.0 1.19 12.81 118.8 1.12 1.0
Dec-08 120 0.0 106.0 1.19 14.00 120.0 1.12 1.0

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