CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition

CHAPTER 16

Unsmoothing of Appraisal-Based Returns

Using past data to infer the future risks and returns of real estate is an important part of real estate analysis, portfolio allocation, and risk management. The primary purpose of this chapter is to focus on one of the most crucial tasks of empirical analysis of real estate returns: data unsmoothing. The effects of smoothed data are not limited to values based on real estate appraisals. Smoothing can affect additional real estate valuation other than appraisals, as well as other alternative investments, such as hedge funds and private equity funds. Therefore, the unsmoothing procedures discussed in this chapter are central to the analysis of alternative investments.

There are substantial challenges faced by real estate appraisers and other financial professionals who are asked to place values on an asset through time, as economic conditions change. Consider a major market movement in the midst of a more general period of financial stability. For example, suppose that the equity market experiences a general and rapid price rise of 10%. It is possible that the reported prices of other asset classes that tend to be correlated with equity markets may indicate a delayed reaction to that rise and the accompanying changes in economic conditions. To the extent that a price or return series demonstrates a delayed response, due perhaps to the valuation methods used by appraisers or other financial professionals responsible for publishing ...