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

Agenda IPD Property Futures pricing IPD UK Index analysis Simulation

“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

IPD Property Futures Pricing TR Estimate IPD Index Level

2014 Calendar Year 2014

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

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

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

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

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

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

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

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

Distribution of portfolio total returns 2014

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)

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

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

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

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

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

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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

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

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%

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

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

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%

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

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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