Legislative and regulatory changes such as the Dodd-Frank Wall Street Reform and Consumer Protection Act have placed renewed emphasis on transparency and independence. The changing landscape of the financial industry is fueled by the desire to earn the public’s trust and will continue to focus on transparency and independence as a means to achieving this goal. Performance measurement and related analyses from independent firms will have a prominent role in the standard operating model for most, if not all, investment processes.
Transparency and independent oversight are critical elements in fair value reporting practices. It has become common for institutional funds to engage an Appraisal Management Firm to perform expert consulting assignments such as external appraisal review, performance measurement and benchmarking, debt valuation and insurable value analysis.
The most common policy is to require external valuations on a quarterly basis for open-end funds. This policy works best in an independence sensitive environment. It is highly recommended that related administrative tasks be outsourced to minimize opportunity costs and to maximize the expertise of professionals who regularly perform these duties for a variety of clients. In a cost sensitive environment, engaging external appraisers on an annual or semi-annual basis and performing quarterly update valuations internally with the support of an Appraisal Management Firm is a recommended practice. This option is more cost effective than engaging the Appraisal Management Firm to perform restricted-use appraisal reports, but provides a relatively similar level of independence and knowledge base.
The impact of active portfolio management such as buying, selling, developments and the injection of capital into retained assets is also a part of contribution analysis. How will an asset under construction impact fund returns through its phases of development? What is the impact of spending capital to refurbish an asset on both income and appreciation returns? How does the purchase of an asset affect the fund’s risk profile and returns? These are all questions answered in a thorough contribution analysis.
Performance attribution inevitably follows the development of benchmarks. To the extent that benchmarks and contribution analysis answers ‘How does the fund compare’, attribution analysis answers ‘Why are the fund’s return different’. For managers promoting investment in their real estate funds or departments charged with explaining fund returns, independently verified benchmarking and attribution analysis is becoming an essential tool. As an example, attribution can answer the question ‘Did the fund outperform the benchmark primarily because of a relatively heavy allocation to multifamily or because a large new lease was signed at one of the fund’s largest office buildings?’ Through contribution analysis, ‘How much did each impact the excess return’ can also be answered.
Although peer comparisons are important, it is arguable more important to have comfort that fair values accurately reflect current market conditions. This includes not only recently closed transactions but also negotiations currently taking place, understanding recent re-trades and deal cancellations as well as market participant sentiments. Market surveys would include analysis of changes in cap rates, discount rates, market rents, NOI growth, absorption, new construction, etc.