When you're considering investing millions of dollars in an apartment property, you want to know everything you can about how that property performs compared to industry averages. There are two challenges to measuring the investment performance of apartment properties: determining the total return on apartments and finding an appropriate measure to which that return can be compared.

Fortunately, due to increased demand for such measures as well as the expansion of sources and application of statistical techniques, there is now a wide array of options for indexing apartment performance.

Real estate returns contain two parts: the net income from owning the property, plus the capital gain or loss associated with the property. In principle, both are simple to measure, but in practice both can be a challenge.

With net income, the main difficulties involve depreciation of capital and accounting rules. What's more, estimating the appreciation component of a property's return without actually selling the asset is an informed judgment at best.

Comparing investment returns

One might want to compare the income return, the price appreciation, or the total return to industry averages. Since there are no government data available to serve as benchmarks, owners and investors rely on data from private providers and from an industry consortium known as the National Council of Real Estate Investment Fiduciaries.

Using reports by its members, NCREIF produces three types of indexes for each real estate asset class (as well as indexes for different geographies): an income index, a capital index, and a total index. These indexes go back to 1978 for most asset types.

There are two points to keep in mind about these indexes: First, property values are mainly based on “market value accounting.” In other words, only a minority of properties in most quarters have true market prices. So the indexes may exhibit a tendency for estimated values to lag behind actual market values, a problem known as appraisal bias. Next, the industry-wide figures involve weighted averages of individual responses, with weights based on market value. In effect, the NCREIF capital index is intended to portray the gain in the value of a hypothetical portfolio of all investment-grade apartment properties.

There are three newer indexes that use sophisticated econometric techniques to remove this bias to arrive at a “cleaner” estimate of the underlying trends. Two of these are associated with the Commercial Real Estate Data Laboratory (CREDL) at the Massachusetts Institute of Technology (MIT); the other is an S&P product.

To get around the appraisal bias in the NCREIF property value data, the Commercial Real Estate Data Laboratory uses only the subset of the NCREIF reports that involve actual transactions.

To avoid the compositional bias associated with transactions data, the labo-ratory uses a technique called hedonic regression analysis that's designed to account for different property characteristics in different time periods.

The result is CREDL's set of Transaction-Based Indexes (TBI). The data laboratory notes that while this procedure addresses two shortcomings, like any statistical product, it is subject to estimation error.

Up by any measure

As you might expect, the TBI appears to be a leading indicator of the NCREIF value index. Most obviously, the TBI shows 2005 appreciation — boosted by condo conversion demand — at almost 33%, while the NCREIF Apartment Price Index shows a more modest 15% gain. In 2006, by contrast, the TBI suggests apartment property prices grew by less than 3%, while the NCREIF data indicates a more substantial 9% pickup.

MIT's data laboratory recently began producing another set of indexes based on transactions data from Real Capital Analytics. The Real Capital Analytics-based index uses the repeat sales technique to avoid the compositional bias.

S&P and its partner GRA (the real estate arm of Charles Schwab Investment Management) just launched a new set of tradable monthly indexes, S&P/GRA Commercial Real Estate Indices (SPCREX). To address the compositional bias issue, it uses a weighting scheme based on stock values and geography, as well as rolling three-month averages. This index has more transactions than the NCREIF database, an advantage, but was only available beginning in 2001.

Currently, NCREIF remains the apartment industry's primary benchmark. Stay tuned to see whether the industry will begin to use other indexes as well as it becomes more familiar with them.

Mark Obrinsky is vice president of research and chief economist for the National Multi Housing Council based in Washington, D.C.