The Effects of Appraisal-Smoothing on Reported Real Estate Risk and Returns for Different Investment Horizons

Since commercial real estate incorporates a vast part of national economies’ wealth, investors and economic experts want to know the value changes on property markets. Alas, there doesn’t exist an undisputed way to track the increase or loss of property values. One method is to calculate appraisal-based indices from value estimates for many single properties. However, even professional appraisers are insecure about the just latent existent market values. So, appraisal values are in suspicion to be biased towards their correspondent true market values. In the literature, biases of different origins (“appraisal phenomena”) are identified. They are adjunctive to the behaviour of surveyors in appraisal processes and to the method of index construction. So property indices leave an uncertainty about the performances and risks of real estate investments. Further, decisions about the allocation of capital flows into the main asset classes stocks, bonds and real estate could be affected by this intransparency. In the past, a comprehensive literature was published, trying to explain the linkage and gap between appraisal-based indices and actual market values of properties. But instead of filling in the gap between values of both concepts, their authors found very different and diverging results. Just in common it seems from the studies, that the volatility - as an investment risk measure - is downward biased in indices, compared to the true market volatility. While the authors followed different research methodologies, no one - to my knowledge - published the results of a simulation study. This paper fills in this gap and tries to deliver more transparency in this issue. The effects of the well-known problem appraisal-smoothing are quantified as well as of other appraisal phenomena. Values are studied for single properties as well as for markets. Additionally, effects on volatilities for different investment horizons are studied.