1. A Simulation approach ERES 2015, 26th June 2015
Charles Ostroumoff, Mark Clacy-Jones, Malcolm Frodsham
A Simulation approach

2. Agenda
IPD Property Futures pricing
IPD UK Index analysis
Simulation

3. “The object of our analysis is, not to provide a machine, or a method of blind manipulation which will furnish an infallible answer, but to provide ourselves with an organised and orderly method of thinking out particular problems: and, after we have reached a provisional conclusion by isolating the complicating factors one by one, we then have to go back on ourselves and allow, as well as we can, for the probable interactions of the factors amongst themselves.”
JM Keynes

4. IPD Property Futures PricingTR
Estimate
IPD Index
Level

5. 2014 Calendar Year
2014

6. Basis Risk
This Paper is focused on the tracking error (creep) between the IPD Monthly and IPD Annual Indices
There also exists the tracking error (basis risk) between the total return of a portfolio and the total return of the IPD Index
Our aim is to devise a simulation model to quantify this “basis risk” and increase the accuracy of our short term forecasting

7. Systematic and idiosyncratic risk
Property has the highest divergence of return i.e. the highest level of standard deviation of excess return relative to its benchmark
For 95% of the variation in returns to be explained by the market, over 200 properties required*
c.f. Equities 45%
To reduce the tracking error / basis risk to less than 1% requires an exponential increase*
‘Portfolio Structure’ & ‘Asset Quality’ – 2 Key Factors
Difficult to assemble a market-tracking portfolio at reasonable cost
Different segments reveal immensely different lot sizes and require immensely different capital investment
Can price smaller players out of the market (Byrne & Lee 2001)
Some properties in some segments experience higher variations in return than others
Equally weighted portfolios do not exist

8. Hypothesis
Why does the IPD UK Monthly Property Index not more closely track the IPD UK Annual Property Index?
Sampling Issue?
Samples should be large enough & diverse enough to not be biased
If sample is unbiased tracking error is a function of individual asset returns & number of assets
Hypothesis:
Tracking error between the two indexes must be due to structural differences

9. Index composition - theory
Indexes are samples of assets
IPD Index samples should be materially free from bias
Multiple portfolios
Heterogeneous assets
Assets valued by multiple valuation firms
Diffused client influence

10. Size & structure of the uk commercial market
Investable Universe
£385bn*
Retail £150bn
Office £157bn
Industrial £43bn
Other £35bn
*End 2013
Source: IPF – The Size & Structure of the UK Property Market

11. IPD UK Annual & monthly index composition
IPD UK Annual Property Index
IPD UK Monthly Property Index
*End 2013
Source: MSCI

12. IPD UK Annual & monthly index composition
IPD UK Annual Property Index
IPD UK Monthly Property Index
Capital Value (£m)
% CV
No. Props
No. Funds
No. Valuers
Max Prop Dominance (% CV)
Max Fund Dominance (% CV)
Max Valuer Dominance (% CV)
Capital Value (m)
Std Retail South East
17,507
9.8
1,327
192 34
2.3
11.8
31.2
3,056
7.1
353 42 16
3.7
10.7
49.9
Standard Retail Rest UK
11,221
6.3
1,369
188 31
0.7
4.1
37.6
3,216
7.4
532 45 15
7.9
41.6
Shopping Centre
26,198
14.6
275
102 18
8.3
32.8
47.4
2,402
5.5 88 33 9
7.2
13.8
43.3
Retail Warehouse
26,677
14.9
1,232
1.3
6.2
39.2
9,307
21.5
484 47 17
3.8
16.9
52.0
Office City
7,459
4.2
237
104 22
4.4
14.4
51.8
1,869
4.3 77 12
4.7
7.3
39.3
Office West End & Mid Town
22,513
12.6
851
131 24
1.9
11.4
51.4
4,655
10.8
136 39 13
4.0
21.3
55.5
Office Rest South East
13,755
7.7
914
184 32
2.6
41.8
5,178
12.0
367 51
11.0
39.9
Office Rest UK
7,073
624
159 26
5.3
2,579
6.0
241 40
3.1
45.6
Industrial South Eastern
18,498
10.3
1,385
190
5.1
8.8
39.0
4,540
10.5
432 46
7.5
42.1
Industrial Rest UK
11,066
1,577
191 35
1.6
30.8
3,810
470
2.9
40.0
Other
16,899
9.4
2,304
200 37
9.5
20.1
2,671
299 36
3.3
9.2
42.6
Retail
81,602
4,203
234 38
2.7
33.6
17,981
41.5
1,457 50
2.0
48.6
Office
50,800
28.4
2,626
220
0.8
7.6
47.5
14,282
33.0
821 53
45.8
Industrial
29,564
16.5
2,962
209
3.2
36.0
8,350
19.3
902 49
41.1
All Property
178,865
100.0
12,095
288 48
1.2
4.8
36.2
43,283
3,479 55 20
7.8
45.7

13. Distribution of asset total returns 2014
Distribution of asset returns has profile which is indistinguishable between the two index frequencies

14. Distribution of portfolio total returns 2014

15. Index tracking errors
Annual Index tends to underperform in years of higher return
Average difference is 0.2 percentage points
Tracking error is 1.3 (standard deviation of differences)

16. Index methodology differences
No difference to data collection or index construction between Annual & Monthly Indexes
IPD UK Monthly Property Index “frozen” so historic data corrections not included but may be corrected in time for IPD UK Annual Property Index
(Though this is not the case at segment level which is unfrozen)
Valuations should in theory all be done as at year-end so no extra information should be available for inclusion in annual valuations

17. Index tracking errors, Evolution by year
Tracking errors tend to grow in a relatively linear fashion throughout the year
1993
2007
1994

18. Segment weight differentials change throughout year
Difference between segment weight in monthly & annual indexes changes month on month, as in this 2014 example
Annual index weights are only known after year end

19. Asset Quality differs between indexes
In most segments equivalent yield is lower in the annual index suggesting assets are on average better quality in the annual index

20. Occupation levels differ between indexes
Monthly Index has marginally higher void rates than the Annual Index and has a higher level of over-renting

21. Notice and disclaimer
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22. Simulation Drivers Income & occupancy at start of the simulation
Yield levels by segment, asset quality and income security
Rental growth by segment and asset quality
Lease events by segment and asset quality
Yield changes by segment, asset quality and income security

23. RENTAL GROWTH TRENDS VARY BY ASSET QUALITY Year to Q3 2014, %
Low* asset quality
High* asset quality
Standard retails:
Central London
9.5
7.4
South east
-0.1
1.3
Rest of UK
-1.5
Shopping Centres
-0.9
0.3
Retail Warehouses
0.0
0.2
Standard offices:
City
13.1
6.6
West End
8.3
10.6
2.8
6.4
1.0
0.9
Office Parks
3.1
0.1
Standard Industrials
2.6
3.6
1.6
1.7
Distribution Warehouses
1.8

24. Yield - by term certain (rack-rented)
VALUATION CAP RATES & CASH FLOW ASSUMPTIONS MAJOR REGIONAL OFFICES, Q2 2014
Yield - by term certain (rack-rented)
Asset Quality
Rent per sq ft
National / Strong Covenant
Local / Weak Covenant
Vacant
2015-'18
2019-'23
2023+
Grade A New
£30.00
9.25%
8.50%
6.50%
5.75%
9.00%
7.75%
7.00%
Grade A Refurbished
£22.50
9.75%
6.25%
9.50%
8.00%
7.25%
Second Hand Good
£18.00
11.00%
10.00%
10.50%
8.25%
7.50%

25. SIMULATION OF HIGH / LOW QUALITY ASSET RETURNS
4 HIGH QUALITY ASSETS:
DIFFERENT LEVELS OF INCOME SECURITY
4 LOW QUALITY ASSETS:
DIFFERENT LEVELS OF INCOME SECURITY
VALUE YEAR 1
Yield - by term certain
(rack-rented)
Asset Quality
Rent per sq ft
National / Strong Covenant
Vacant
2015-'18
2019-'23
2023+
Grade A New
£30.00
9.25%
8.50%
6.50%
5.75%
Capital value
£32m
£35m
£46m
£52m
Yield - by term certain
(rack-rented)
Asset Quality
Rent per sq ft
Local / Weak Covenant
Vacant
2015-'18
2019-'23
2023+
Second Hand Good
£18.00
11.00%
10.50%
8.25%
7.50%
Capital value
£16m
£17m
£22m
£24m
VALUE YEAR 2
Yield - by term certain
(rack-rented)
Asset Quality
Rent per sq ft
National / Strong Covenant
Vacant
2015-'18
2019-'23
2023+
Grade A New
£33.00
9.00%
8.25%
6.25%
5.50%
Capital value
£37m
£40m
£53m
£60m
Change, %
16%
14%
15%
Yield - by term certain
(rack-rented)
Asset Quality
Rent per sq ft
Local / Weak Covenant
Vacant
2015-'18
2019-'23
2023+
Second Hand Good
£19.80
10.75%
10.25%
8.00%
7.25%
Capital value
£18m
£19m
£25m
£27m
Change, %
13%
12%
14%
+10%
+10%
MARKETAVERAGE 14%
HIGH QUALITY AVERAGE 15%
LOW QUALITY AVERAGE 13%
Change in asset capital values depends on rental growth and yield changes

26. Simulating Market Returns
There is an asset quality / income security ‘factor’ to market segment returns
In other words the IPD Monthly Index has a different exposure by type & region and to income security and asset quality factors.
Fund Managers should take into account the asset quality and income security of the IPD Index when pricing futures contracts

27. SIMULATION OF MARKET RETURNS
5 HIGH QUALITY ASSETS
5 LOW QUALITY ASSETS
Yield - by term certain
(rack-rented)
Asset Quality
Rent per sq ft
National / Strong Covenant
Vacant
2015-'18
2019-'23
2023+
Grade A New
£30.00
9.25%
8.50%
6.50%
5.75%
Yield - by term certain
(rack-rented)
Asset Quality
Rent per sq ft
Local / Weak Covenant
Vacant
2015-'18
2019-'23
2023+
Second Hand Good
£18.00
11.00%
10.50%
8.25%
7.50%
Long-lease
Letting
Non-renewal
Renewal
Tenant bust
Year 0
Rent Passing0
£30.00
Vacant
Yield0
5.75%
9.25%
8.50%
Capital Value0
£52m
£32m
£35m
Year 1
Rent Passing1
Yield1
6.50%
Capital Value1
£46m
Change, %
-11.5%
62.5%
-8.6%
48.6%
-38.5%
LEASE EVENT->
LEASE EVENT->
Long-lease
Letting
Non-renewal
Renewal
Tenant bust
Year 0
Rent Passing0
£18.00
Vacant
Yield0
7.50%
11.00%
10.50%
Capital Value0
£52m
£32m
£35m
Year 1
Rent Passing1
Yield1
8.25%
Capital Value1
£46m
Change, %
-8.3%
50.0%
-5.9%
41.2%
-33.3%
MARKET AVERAGE 17%
MARKETAVERAGE 15%

28. Simulating Market Returns
The market average capital value change depends upon:
Initial income and occupancy characteristics
Rental value and yield changes
Lease ‘events’ (lettings, vacancies) through the year
The spread of asset capital value changes depends on valuation yields by asset quality
The distribution of asset capital value changes depends on lease event probabilities
Few of these inputs are known

29. Disclaimer: While every effort has been made to ensure that the data quoted and used for the research behind this document is reliable, there is no guarantee that it is correct, and Real Estate Strategies Limited can accept no liability whatsoever in respect of any errors or omissions. This document is a piece of economic research and is not intended to constitute investment advice, nor to soliciting dealing in securities or investments.

30. Charles Ostrumoff
Arca PRM
20 Hanover Street
London, W1S 1YR
Mark Clacy-Jones
MSCI
Ten Bishops Square
London, E1 6EG
Malcolm Frodsham
RES
Rex House
4-12 Regents Street
London, SW1Y 4PE