Investment Performance of Canadian

Commercial Real Estate

A joint research project of the

Pension Real Estate Association (PREA) and the Real Property Association of Canada (REALPAC)

Released March 2018

Commercial Real Estate Performance– 1985 to 2016

Appreciation index is net of capex; i.e., does not include the effect of capital improvements on property values. Based on unsmoothed version of the REALPAC/IPD Canada Property Index from 2000, and the Russell Canada Property Index prior to 2000. See Technical Appendix for details. All returns in CAD terms.Sources: PREA Research, MSCI, Statistics Canada (for inflation)

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-100

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urn

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= 1

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)

Total Return Index

Capital Appreciation Index

Inflation Adjusted Capital Appreciation

1526.2

164.9

80.9

$100 Invested in Real Estate, Equities, or Bonds

Based on total returns to S&P/TSX Composite, FTSE TMX Canada Universe Bond Index, and unsmoothed version of the REALPAC/IPD Canada Property Index (Russell Canada Property Index prior to 2000). See Technical Appendix for details on real estate returns. All returns in CAD terms.Sources: PREA Research, MSCI, FTSE Russell, Thomson Reuters Datastream

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$-

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$1,80019

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Val

ue

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ent

(19

85

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10

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real estate equities bonds

$1526

$1168

$1011

Total Returns by Year

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tota

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real estate equities bonds

Based on total returns to S&P/TSX Composite, FTSE TMX Canada Universe Bond Index, and unsmoothed version of the REALPAC/IPD Canada Property Index (Russell Canada Property Index prior to 2000). See technical appendix for details on real estate returns. All returns in CAD terms.Sources: PREA Research, MSCI, FTSE Russell, Thomson Reuters Datastream

Compound Annual Returns, to 2016

1 year 3 years 5 years 7 years 10 years 20 years

Real Estate 5.4% 6.7% 8.8% 10.5% 8.8% 11.1%

Equities 21.1% 7.1% 8.2% 6.9% 4.7% 7.3%

Bonds 1.7% 4.6% 3.2% 4.6% 4.8% 5.8%

Based on total returns to S&P/TSX Composite, FTSE TMX Canada Universe Bond Index, and unsmoothed version of the REALPAC/IPD Canada Property Index (Russell Canada Property Index prior to 2000). See Technical Appendix for details on real estate returns. All returns in CAD terms.Sources: PREA Research, MSCI, FTSE Russell, Thomson Reuters Datastream

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Risk-Adjusted Performance, 1986-2016

Real Estate Equities Bonds

Average return (arithmetic)

9.4% 9.4% 7.9%

Volatility 7.2% 15.7% 5.9%

Sharpe Ratio* 0.54 0.28 0.64

Alternative measure of risk, Maximum Drawdown**:

Real Estate Equities Bonds

-13.0%(1990 to 1993)

-33.0%(2007 to 2008)

-4.3%(1993 to 1994)

* Sharpe calculated as average excess return above one year Treasury yield, divided by volatility of excess return. Gives average return per unit of risk; is commonly used to measure risk-adjusted performance. ** Maximum drawdown is defined as the greatest peak-to-trough loss experienced over a time period (1986-2016). Measured here based on annual returns so assumes any buying or selling would be at the beginning/end of calendar year. Period of maximum drawdown given in parentheses. All figures based on total returns to S&P/TSX Composite, FTSE TMX Canada Universe Bond Index, and unsmoothed version of the REALPAC/IPD Canada Property Index (Russell Canada Property Index prior to 2000). See Technical Appendix for details on real estate returns. All returns in CAD terms.Sources: PREA Research, MSCI, FTSE Russell, Thomson Reuters Datastream

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Diversification Potential - Correlations

Real estate Equities

Equities 0.06

Bonds -0.21 0.08

Based on annual total returns, 1986 to 2016, to S&P/TSX Composite, FTSE TMX Canada Universe Bond Index, and unsmoothed version of the REALPAC/IPD Canada Property Index (Russell Canada Property Index prior to 2000). See Technical Appendix for details on real estate returns. All returns in CAD terms.Sources: PREA Research, MSCI, FTSE Russell, Thomson Reuters Datastream

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Technical Appendix – Measuring Canadian Real Estate Returns

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Data sources for Canadian real estate returns:Real estate returns are based upon returns to the REALPAC/IPD Canada Property Index back to 2000 (the beginning of the index). From 1985 to 2000, returns are from the (now defunct) Russell Canadian Property Index (RCPI). As the indices are partially updated during the year, as properties are appraised, quarterly returns can be misleading and therefore annual returns are utilized throughout this report. Returns are total returns (including capital appreciation and income) unless otherwise stated, and measured including all property types. All returns are in CAD terms.

Unsmoothing appraisal based returns:The REALPAC/IPD Canada Property Index (and its predecessor, the RCPI) are appraisal based indices in which values are based upon periodic property appraisals. It is well known that appraisal based indices are artificially smooth, and will underestimate actual return volatility and lag actual changes in the market. To correct for this the returns used in this report undergo a procedure to unsmooth them.

A more accurate measure of the volatility of property values, which does not suffer from appraisal smoothing, can be obtained from a repeat-sales index based on actual transaction prices. Such an index is available for Canada: the Canadian Commercial Property Price Index (Canadian CPPI) compiled by Real Capital Analytics. The Canadian CPPI is available on a monthly basis going back to 2006. While a transaction price based index such as the Canadian CPPI provides a much better picture of changes in prices through time (and therefore a better picture of price returns to property), for the purposes here of examining the long term investment performance of real estate it has two drawbacks: (1) the lack of a long history, only being available back to 2006 in Canada, and (2) it is a price-only index and therefore omits the income return to real estate, an important component to overall, total returns. Because of this we use the appraisal-based indices as the basis of our Canadian real estate returns, but unsmooth them to correct for appraisal lag using the Canadian CPPI*.

To unsmooth the appreciation returns, we use the same method as used by Geltner (1993) and others. If Rt represents the “true” appreciation return in period t, and Rapp,t is the appreciation return as measured from an appraisal based index, then:

* We thank Real Capital Analytics for allowing the use of their data.

1t,appt,app

t

R1RR

where α is the unsmoothing parameter which depends on how much weight appraisers put on past values as opposed to current market signals when appraising a property. To estimate α, we make use of the Canadian CPPI transaction price-based index. Annual returns on the Canadian CPPI are available back to 2007. We apply the unsmoothing formula above to the appreciation component of the REALPAC/IPD Canada Property Index back to 2007, where α is chosen so that the volatility of the unsmoothed appraisal based capital appreciation return is equal to the (presumably “true” ) volatility of the Canadian CPPI price index. This results in a parameter estimate of α = 0.843. This is close to the estimate of α found for Canadian real estate reported in Clayton, Geltner, and Hamilton (2001) of 0.815 so we feel confident that it represents a reasonable approach to unsmoothing Canadian real estate returns. We apply the unsmoothing function with the estimated parameter to the appreciation returns back to 1985 (note that the unsmoothing process required the loss of the first year of data and therefore our unsmoothed return series begins in 1986). Because we are estimating the unsmoothing parameter based on returns from 2007-2016 and then applying that parameter to returns back to 1985, we are assuming that the parameter does not change significantly over time.

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Assumption on Capital ExpendituresThe appreciation component of the REALPAC/IPD Canada Property Index is measured net of capital expenditures (CAPEX). That is, CAPEX is deducted from the appreciation component of return in the REALPAC/IPD Canada Property Index. Hence the appreciation return does not reflect the effect of capital improvements to the properties’ values. RCA’s Canadian CPPI is based on actual transaction prices and therefore includes CAPEX in property values. Estimating a desmoothingparameter as above by equating volatility on the two return series therefore involves an implicit assumption regarding CAPEX. Specifically, the assumption is that CAPEX as a percentage of value is constant each period. Given that we are dealing with annual returns and an index averaged across many properties, this would appear to be a reasonable assumption.

Incorporating Income ReturnsThe above process results in an unsmoothed series of appreciation returns to real estate. However, we must incorporate an income component to obtain the total returns to property in Canada. We first generate a value index from both the original and unsmoothed versions of the REALPAC/IPD Canada Property Index (and RCPI). Each year, we multiply the income return from the REALPAC/IPD Canada Property (and RCPI) Index by the beginning of period level of the original, smoothed value index to generate an estimate of income in pseudo-dollar form. We then divide that amount by the beginning of period level of the unsmoothed value index to generate an unsmoothed income return for each period.

Total Returns to Real EstateWith the unsmoothed appreciation returns and unsmoothed income returns to real estate, we can now calculate the unsmoothed total returns. However, because we are dealing with annual data, simply adding the two components together will underestimate total returns.

To see this, consider a simple two quarter example: In a quarterly index (such as the REALPAC/IPD), the income (RIt) and appreciation (RAt) returns are added together to generate the total return for the quarter (RTt). If one wants to calculate the return over a two-quarter period, RT,1-2, then the two quarters’ returns should be compounded:

𝑅𝑇,1−2 = 1 + 𝑅𝑇1 1 + 𝑅𝑇2 − 1

= 1 + 𝑅𝐼1 + 𝑅𝐴1 1 + 𝑅𝐼2 + 𝑅𝐴2 − 1

= 1 + 𝑅𝐼1 1 + 𝑅𝐼2 − 1 + 1 + 𝑅𝐴1 1 + 𝑅𝐴2 − 1 + 𝑅𝐼1𝑅𝐴2 + 𝑅𝐴1𝑅𝐼2= 𝑅𝐼,1−2 + 𝑅𝐴,1−2 + 𝑅𝐼1𝑅𝐴2 + 𝑅𝐴1𝑅𝐼2

Adding the two-quarter income and appreciation returns omits the cross-product terms and underestimates the two-quarter total return by 𝑅𝐼1𝑅𝐴2 +𝑅𝐴1𝑅𝐼2. These terms essentially represent income earned on past appreciation, and appreciation earned on past income. Omitting the cross-product terms not only underestimates the total return over a period, but also leaves the resulting return not comparable to returns for equities and bonds which assume reinvestment of earnings throughout the period.

While the cross-product terms may be small in the two quarter example, over the course of compounding four quarterly returns to generate annual returns they do add up. For example, for the original, smoothed REALPAC/IPD Canada Property Index, the difference between the annual total return and the sum of the annual income and annual appreciation returns averages 13 basis points (bp) per year.

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To estimate annual total returns for unsmoothed real estate and correct for this bias, for each year we calculate a bias correction and add it to the sum of annual income and annual appreciation. The bias correction is based on the following: Since we do not know the actual quarterly (unsmoothed) income and appreciation returns, we cannot calculate the cross-product terms directly. We therefore make the assumption that returns each quarter

within a year are identical. That is, in each year we estimate the quarterly income and appreciation returns as 1 + 𝑅𝑎𝑛𝑛𝑢𝑎𝑙1/4 − 1 . If we drop time

subscripts on the income and appreciation returns , as we are assuming them equal for each quarter in a year, then for a particular year the estimated quarterly component returns are 𝑅𝐼 and 𝑅𝐴. Note that in the above, two-quarter, example, the bias is therefore equal to two terms of 𝑅𝐼𝑅𝐴. In the case of annual returns and compounding four quarters together simple algebra tells us that the relevant cross-product terms (i.e. the bias to be corrected) is based on: 12 terms of 𝑅𝐼𝑅𝐴 , 12 terms of 𝑅𝐼𝑅𝐼𝑅𝐴 , 12 terms of 𝑅𝐼𝑅𝐴𝑅𝐴 , six terms of 𝑅𝐼𝑅𝐼𝑅𝐴𝑅𝐴 , four terms of 𝑅𝐼𝑅𝐴𝑅𝐴𝑅𝐴 , and four terms of 𝑅𝐼𝑅𝐼𝑅𝐼𝑅𝐴 . For each year, we calculate all of these terms using our estimated, equal quarterly returns for that year, sum them up, and add that bias correction to the sum of annual income and appreciation returns to generate annual total returns.

Because we are assuming that quarterly returns are equal within each year to estimate our bias correction, it is important to test whether this is creating its own bias. As an experiment, we apply this bias correction to the original REALPAC/IPD Canada Property Index to see how close it comes to the actual total returns (which are known for the original, smoothed index). We find that, on average, the bias corrected total return estimate underestimates actual total returns by only 2 bp per year (a far smaller bias than when not correcting). The largest underestimation of actual returns for any one year is 14 bp, and the largest over estimation is 8 bp. Hence, this approach appears to substantially reduce the bias in annual total returns, while the remaining bias is still, on average, a small underestimation of total returns to real estate.

References

Clayton, J., D. Geltner and S.W. Hamilton (2001), “Smoothing in Commercial Property Valuations: Evidence from Individual Appraisals,” Real Estate Economics 29:3, 337-360.

Geltner, D. (1993), “Estimating market Values from Appraised Values Without Assuming an Efficient Market,” Journal of Real Estate Research 8:3, 325-346.

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The information and materials contained in this report are provided for informational purposes only and are not intended to be construed as investment advice. The information and materials contained in this report are provided "as is" and "as available" and as such, neither PREA nor REALPAC warrant the accuracy, adequacy or completeness of this information and materials and expressly disclaims liability for errors or omissions in this information and materials.

Contacts:Greg MacKinnon Sandra Dos SantosDirector of Research Director, Industry Affairs & CompliancePREA REALPAC860-785-3847 416-642-2700 x 222greg@prea.org sdossantos@realpac.ca

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