Learning Outcomes
After reading this article, you should be able to explain key valuation methods for real estate and infrastructure, distinguish income and appraisal approaches, evaluate risk premiums, and recognize limitations of appraisal-based data. You will be able to apply and interpret income capitalization and discounted cash flow techniques, address appraisal smoothing, and understand the implications of infrastructure asset characteristics within a CFA Level 3 context.
CFA Level 3 Syllabus
For CFA Level 3, you are required to understand the principles and practical issues involved in valuing real estate and infrastructure investments. In particular, revision should focus on:
- Assessing and comparing income-based and appraisal-based valuation methods for real estate and infrastructure
- Discussing how appraisal data may bias risk and volatility estimates
- Calculating and interpreting capitalization rates, discount rates, and net operating income (NOI)
- Understanding the impact of appraisal smoothing and illiquidity on estimated returns and risk
- Evaluating infrastructure assets’ valuation, considering regulatory or contractual elements and limited observable prices
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- What are the main differences between income-based and appraisal-based approaches to valuing commercial real estate?
- How does appraisal smoothing affect the risk estimates of direct real estate and infrastructure when incorporated in a multi-asset portfolio?
- Describe how net operating income (NOI) and the capitalization rate are used to value income-generating properties.
- What unique appraisal challenges do infrastructure assets present compared to traditional commercial property?
Introduction
Real estate and infrastructure asset valuations are distinctive in their use of income-based approaches, reliance on periodic appraisals, and the influence of illiquidity and smoothing on reported data. For CFA Level 3, competence in applying these techniques and recognizing data limitations is frequently tested where appraisal smoothing can misrepresent volatility and correlation, leading to faulty multi-asset portfolio conclusions.
Key Term: Appraisal-based returns
Appraisal-based returns are return series for illiquid assets, such as commercial property or infrastructure, constructed from periodic third-party valuations or appraisals, rather than frequent market transactions.Key Term: Smoothing
Smoothing is an effect in which appraisal or estimated returns display artificially dampened volatility and correlation as compared to transaction-based returns, often due to infrequent or staggered valuation updates of individual assets.
Real Estate Valuation Approaches
Income-based Valuation
The dominant method for commercial property and income-producing infrastructure is the income approach, where value is derived from an asset’s capacity to generate net operating income (NOI).
Key Term: Net Operating Income (NOI)
NOI is the annual income expected from a property after deducting vacancy losses and operating expenses but before interest, taxes, depreciation, or amortization.
The most common techniques are:
- Direct Capitalization: Value is estimated by dividing NOI by a capitalization rate (cap rate).
- Discounted Cash Flow (DCF): Value is the present value of forecast future cash flows, discounted at a risk-appropriate rate.
Key Term: Capitalization Rate (cap rate)
The cap rate reflects the required rate of return or yield on a property, incorporating risk-free rates plus risk and illiquidity premiums.
Worked Example 1.1
A multi-tenant office building produces NOI of $1,200,000 and regional cap rates are 5.5%. What is the property’s indicative value under direct capitalization?
Answer:
Value = NOI / cap rate = $1,200,000 / 0.055 = $21,818,182.
Appraisal and Its Impact on Return Measurement
Appraisal-based Valuation
Appraisals are typically performed quarterly or annually by independent valuers, especially for illiquid assets with infrequent trading. As a result, published returns of direct real estate or unlisted infrastructure exhibit serial correlation and artificially low volatility—a phenomenon known as appraisal smoothing.
Worked Example 1.2
A pension fund holds retail malls appraised annually. Portfolio return volatility is 5%, while public REITs in the same region show 15% volatility. What is a likely explanation for the difference?
Answer:
The lower volatility is mainly due to appraisal smoothing, not genuine lower risk.Key Term: Appraisal smoothing
Appraisal smoothing occurs when return variation is dampened by infrequent or subjective revaluations, causing understated risk and correlation estimates.
Appraisal Smoothing: CFA Portfolio Risk Implications
Smoothing can distort asset allocation decisions by:
- Underestimating the contribution of real estate or infrastructure to total portfolio volatility
- Underestimating correlations with other asset classes and overestimating diversification benefits
- Biasing risk–return efficient frontiers
Exam Warning
Many candidates overstate the diversification benefit of direct real estate because they ignore appraisal smoothing. Remember, use unsmoothed or transaction-based series for realistic multi-asset risk analysis.
Infrastructure Asset Valuation: Special Considerations
Infrastructure assets (such as toll roads, airports, or utility networks) are long-lived, often monopolistic, and may be regulated. Their valuation requires:
- Discounting contracted or regulated cash flows over long horizons, often with explicit inflation linkage
- Incorporating residual value assumptions based on asset life, concession expiry, or regulatory regime
- Adjusting discount rates for country, regulatory, and liquidity risk
Infrastructure investments are typically less frequently traded than commercial property. Appraisals are often based on modelled rather than observable market prices for comparable assets.
Key Term: Infrastructure asset
A real asset, usually physical and essential for society, which generates predictable cash flows under long-term contractual, regulatory, or monopoly regimes.
Worked Example 1.3
A regulated water utility expects after-tax operating cash flows of $20m/year for 15 years, with a regulatory WACC discount rate of 6%. What is the current asset value (ignore terminal value)?
Answer:
Value = $20m × [(1 – (1 + 0.06)⁻¹⁵)/0.06] ≈ $20m × 9.712 = $194.24m.
Appraisal Issues in Private Real Estate and Infrastructure
- Appraisal inputs (NOI, cap rates, discount rates) may be difficult to estimate reliably, due to tenant quality, lease covenants, and market uncertainty.
- Direct property appraisal lags actual market prices, especially during rapid market moves.
- Illiquidity further biases risk and correlation estimates, complicating performance measurement and benchmarking.
Summary
Income-based and appraisal-based valuations dominate real estate and infrastructure. Smoothing leads to understated volatility/correlation, distorting portfolio analytics. Understand and apply cap rate and DCF approaches, factoring in illiquidity, appraisal periodicity, and estimation error. For CFA Level 3, always challenge low-risk assumptions from smoothed returns—focus on the economic reality reflected by transaction prices or unsmoothed series.
Key Point Checklist
This article has covered the following key knowledge points:
- Differentiate income-based (NOI/cap rate, DCF) and appraisal-based real asset valuations
- Calculate property value using NOI and cap rate; understand discount rate components
- Identify and explain appraised-based returns and the effect of smoothing
- Recognize the pitfalls of using unadjusted appraisal data for portfolio risk analysis (volatility, correlation)
- List practical challenges in valuing infrastructure (illiquidity, contractual cash flows, regulatory discount rates)
- Apply correct adjustments for appraisal smoothing in risk estimates
Key Terms and Concepts
- Appraisal-based returns
- Smoothing
- Net Operating Income (NOI)
- Capitalization Rate (cap rate)
- Appraisal smoothing
- Infrastructure asset