Quantifying risk in commercial realty

Well-functioning markets thrive on risk and deciding how to value it, but to assess risk, markets rely on knowing what they don’t know. Uncertainty, or not knowing how much risk is present, is a market killer.

One tool markets use to help quantify uncertainty and turn unknowns into risks is the index, a method of measuring the value of a defined section of a market. Long a staple of stock markets — think of the Dow Jones Industrial Average or the S&P 500 — indices enable markets to better value risk and, therefore, to make better decisions.

Until recently, however, indices barely existed for a vital financial sector: commercial real estate. David Geltner, professor of real estate finance at the MIT Center for Real Estate (CRE) is pioneering new approaches to overcome the deficit and share the benefit of real estate indices for markets around the world.

“Lots of light shines on securities markets,” says Geltner. “Data on trades and prices is public information. But the commercial real estate market has been in the dark, with little information about risk. My work helps to shine a light in that dark room.”

Traditionally, the only types of commercial property price or investment performance index regularly produced and published were based on appraised values. Since 2005, Geltner and the CRE’s Commercial Real Estate Data Laboratory have led in the development of three new types of indices for tracking the price and investment performance of commercial real estate using property sales prices, and also using stock market valuations of real estate investment trusts (REITs).

“It’s very challenging to make a rigorous price index for real estate,” says Geltner, who holds joint appointments in the Department of Urban Studies and Planning and the MIT Institute for Data, Systems, and Society. “Comparing the price of a property today with the price a different property sold for yesterday or last year won’t show you the state of the market. If properties are traded as REITs, you can develop indices based on stock market prices for the REIT shares.”

Commercially available indices that have been developed using techniques pioneered in CRE now cover dozens of major metropolitan areas in the country, as well as overseas in the United Kingdom and Japan, and soon will likely include other major cities in Europe, Asia, and Australia.

“Nobody has done more than Professor Geltner to illuminate the shortcomings of existing measures of returns on investments in private real estate markets and to develop better measures that come ever closer to measuring true returns, volatilities, and correlations,” says Brad Case, senior vice president at the National Association of Real Estate Investment Trusts. “Trillions of dollars are invested in real estate by endowments, foundations, and pension funds, and Dr. Geltner’s work has helped managers avoid some of the bad real estate investment decisions that plagued such institutions for decades.”

Intent on making analytics mainstream among real estate decision-makers, Geltner likes to develop tools that do not require highly specialized expertise. He is currently writing a book with Richard de Neufville, MIT professor of civil and environmental engineering, to guide engineers and developers in quantifying risk and valuing flexibility in development projects, by running Monte Carlo simulations in Excel.

Geltner, who describes real estate as a field in which “everything is relevant,” obtained a master’s degree in 1976 at Carnegie Mellon University in urban and public affairs. “I took courses in economics, finance, political science, sociology, history, and law.”

During the next decade as a researcher and doctoral candidate at MIT, however, Geltner found his life’s work. “I fell in love with the MIT ‘mens-et-manus’ ethic,” says Geltner, referring to the Institute’s motto of “mind and hand.” “Here, we use our brains to make the world a better place, cutting across disciplines and linking fields to do that.”

His research shifted to private sector construction — real estate development — where economics more than politics influences decisions. While teaching real estate finance at the University of Cincinnati from 1989 to 2002, Geltner saw that his field lacked a rigorous textbook. He decided to write it, working with Professor Norman G. Miller, the founder of UC’s real estate program.

Published in 2001 and now in its third edition (2014), “Commercial Real Estate Analysis and Investments” is the most widely cited textbook in its field. The book responded to the needs Geltner observed in his students at both UC and MIT. In the fall of 1998, while on sabbatical, he taught real estate finance at CRE. His lecture notes became the basis of the book.

“At Cincinnati, my students only had basic finance,” says Geltner. “At MIT, the students were architects and engineers who never studied finance. The course and book had to take students from ground zero to the cutting edge and even beyond.”

The resulting textbook merges urban economics with corporate finance and capital markets theory. “Real estate combines all three,” says Geltner. “When buying property, you are both a corporate financial manager and an investor. You also need to know urban economics to assess the value of the land and buildings.”

In 2002, Geltner joined CRE. While conducting research, he also teaches three courses in the center’s one-year master’s degree program in real estate development.

“MIT is such an incredible place to work,” says Geltner. “Our students share a desire to improve our built environment. Other faculty members teach them to build better buildings. I help them learn how to finance these projects so they are good investments. And my research helps to promote a market that makes better use of capital and avoids excessive borrowing that can lead to a crash. Investors and markets operate more efficiently with more light and less uncertainty.”

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