The usefulness of indices relies on getting a good understanding of how they are put together, as Shayla Walmsley reports

They are based on estimates and are sometimes months behind what is going on in the market. Advocates of real estate indices have their work cut out. One of them, Gareth Parker, director of indices at IPD, claims the valuations that make up that firm's indices are based on "a solid set of principles".
"Valuation gives you a better idea of what it's worth now, with no speculation," he says. In contrast, transaction-based indices effectively speculate based on unrepresentative samples.
Yet there is a major problem with the appraisal approach: these indices do not catch even significant shifts in the market in a timely manner because they have no forward-looking element. "If you look over the past few months, the market clearly believed UK property values were going to fall but the indices haven't reflected that," says Parker.
In other words, IPD is effectively measuring history. This absence of predictive power represents an inherent bias.
 "Economic uncertainty now looks different than it did six months ago," says Paul Frischer, founder of REXX Index. "The process is a floating barometer of returns - but not in real time and not reflecting the events of the time measured. These indices are a rear-view mirror."
Transaction-based indices offer two clear advantages over appraisal-based ones. The first is that they measure real prices - what investors are willing to pay, rather than what valuers think they should pay. Appraisals benchmark properties against each other and estimate, extrapolating from the recent past.
"There's a difference between the real price - the transaction price - and an appraisal price, which is really an estimate," according to David Blitzer, managing director and chairman of the index committee at Standard & Poor's, which recently launched a transaction-based index for US commercial and residential real estate.
The second is that, at least in theory, they can capture market change quickly. It is largely theoretical because the property market simply does not register a sufficient volume of transactions to allow equity market-style sensitivity, and illiquidity is inescapable.
"The real difference is the speed of the whole process. In equities, it's rapid - it takes place in minutes. You state the bid or offer. You make the trade or you don't. You'll look at where the market is but it's unlikely to move by a huge amount," says Blitzer.
But, arguably, transactions are more likely than appraisals to be influenced by irrational factors - market sentiment, rather than intrinsic value. Not so, says Blitzer, who (perhaps ironically) worked on the US residential index with the Yale behavioural economist Robert Schiller, the godfather of irrational investors.
"Appraisals are as likely to be based on momentum as transactions," he says. "But to know what something is worth is to know whether someone will pay for it in cold cash."
So which wins: appraisals or transactions? Probably neither. "Appraisal-based indices are based on infrequent, subjective valuations, and they're subject to smoothing, lagging and seasonality. But there are also problems with transaction-based indices. There's no indication of variations in liquidity not affected by prices," says Frédéric Ducoulombier, director of asset management education at EDHEC, the French business school.
The real damage to accuracy with transaction-based indices is not how they measure but what they measure. Even critics agree that appraisal-based indices are broadly functional. Frischer, for instance, points out that because appraisals are conducted at the same intervals, "you could functionally trade the UK for the US".
Transaction-based indices are altogether more problematic, essentially because of straightforward sample bias, additionally because they are unable to measure motive. Arguably, they are as ill-equipped as appraisal-based indices to capture market sentiment, trends or dynamics.
"You need a sufficient number of transactions and two measurement points. But then which measurement is the correct one? With a transaction index, you're measuring what? It doesn't compare returns. It's only a small sample of what one buyer and one seller is willing to do," he says. "It depends on the assumption that you can measure motives. But the seller could be highly leveraged or facing a tax event and be forced to sell," says Frischer. "Appraisals could be right - but late. Transactions could be inherently wrong."
His own approach is to factor in more data - and more kinds of data, effectively - as in the case of its recently launched commercial property derivatives index - correlating real estate and financial market information. REXX takes into account not only rent but also risk premium and inflation.
 "There's an inherent, inverse relationship that can take into account micro events in a market. You measure the change in asking rents, add the risk premium and inflation. You're not trying to fit it to a curve," he says.
REXX plans to bring this approach to Europe as early as this year. But is it not a little obvious - effectively factoring in real estate market drivers and the Taylor rules that govern central banks' interest rate decisions? And if it is, why did it take so long? 
"Because I was only born in the 1950s," says Frischer. "Look, you have everyone in the same industry, thinking in the same way and looking at the same solution. Dogs only see in black and white. I'm trying to explain a rainbow to all the other dogs."
There is another possible explanation for why it's taken so long to develop credible data - if indeed such there is. It's that the index just doesn't matter that much - at least not to investors.
The paucity of representative, timely data may well obscure what is going on in the market, for instance, but it represents an opportunity for sellers of property's currently most-hyped product type: derivatives.
Parker claims derivatives will provide a boost to the appraisal-based index business. "Derivatives have to be based on a real thing - a real indication of real values of real properties."
So are the index one-uppers wasting their time? Even Frischer appears to suggest timeliness and even accuracy are not essential. Appraisal-based indices, he points out, "process after the time they're measuring. That doesn't make them bad - but it does mean they won't reflect the market."
What matters more than the data used in the index is mutual confidence. "Both parties to derivatives trades need to be confident that the other side isn't fixing the numbers," says Blitzer. "There's pressure to use indices because they're auditable. Especially in the US, where questions have been raised by investors over the past few years, it's important that at that end of the business the auditor can look up the paperwork."
In the meantime, index-creators could well shoot themselves in the abacus. According to Ducoulombier, the proliferation of indices could damage nascent investor interest in derivatives by puzzling investors and reinforcing a wait-and-see attitude. He points to the US market, which "risks fragmentation and could be stillborn if deals were distributed between indices in a way that prevented the emergence of a pool of liquidity large enough to support a sustainable market".
He adds: "The best possible indices are those that are widely accepted. Traditionally, indices have been based on appraisal values but that doesn't mean you can't have transaction-based indices. [We] found that investors reject indices based on agents' opinions. Apart from that, there is no clear lead of one type of index over another."
In any case - and despite recent hype around their inflation-hedging potential and a ‘natural' market created by uncertainty - it seems derivatives will take some selling to investors.

A recent study of 141 European institutional investors conducted by EDHEC found little appetite for property derivatives. The study found that only 5% had invested in index-based property vehicles, with a further 16% planning to invest before the end of the year. More than 80% had no plans to invest in property derivatives, although the fact that pension funds cited lack of familiarity, in contrast to other investors'
concerns over inadequate products and regulatory constraints, suggests caution rather than outright resistance.
Iain Reid, Protego Real Estate Investors CEO and chairman of the Property Derivatives Forum, has long been a champion of real estate derivatives. Back in March, he bullishly stated that their momentum as an asset sub-class was "irresistible". Now he attributes investor reluctance to "human nature".
"Clearly, it's still a novel way of accessing the market and human nature is characterised by fear and laziness," he says. "They have not yet realised that, if they don't use them, they're limiting the tools available to them. It isn't a fringe pursuit - well, actually, it is at the moment but all major property investors in time will be grappling with it because everyone else is and they can't afford to be behind the curve."
 Ducoulombier likewise claims the limitations of indices are not necessarily major issues either for investors or the development of the derivatives
Take Hong Kong, for example. In 2006, property firm CB Richard Ellis and GFI, the US brokerage, launched a joint venture to broker Hong Kong property derivatives based on an index developed at the University of Hong Kong.
The partners, having already set up a derivatives market in the UK based on IPD data, created their own Hong Kong residential index in the absence of an existing one. Given sufficient expertise, it seems derivatives need a basis in credible, but not necessarily comprehensive, data.
"I don't see it as a problem," says Chris van Beek, senior broker at GFI. "As long as I know how the index has been set up, as long as I know the flaws and the methodology and I trust the index provider, I'm willing to trade."
He adds: "You could always say that the index only covers a small part of the market. NACREIF coverage isn't large but investors don't mind as long as they're aware."
KW Chau, who developed the Hong Kong residential index for GFI at the University of Hong Kong, published a paper outlining both the index's method and its flaws. "We gave the information to all potential players - five banks and one non-bank financial institution - and they were happy with the robustness of the index," says van Beek. "There's a lag of up to eight months but it isn't a major hurdle."
Drawbacks in the underlying indices "are not a limiting factor for investors," says Reid. "There are opportunities. The imperfect market can be an advantage. But it's as well if you know what's going on."
He adds: "An index can't be an absolute, up-to-the-minute reflection of the market. If you're in that market, you understand and accept that. Then you assess whether the market downturn is going to go any further and factor that into pricing. Currently, there are opportunities for anyone with cash. It's a discounted market in every medium, including derivatives. Everyone understands how an index works and how the market works. If you think one directly reflects the other, you don't get it."
The problem is that some pension fund investors may not, in fact, get it - that they lack the expertise to seize on derivatives as the industry's next big trend. 
Understanding indices means acknowledging their limitations. Stephen Ashworth, a partner at derivatives portfolio valuation and risk management services company REECH, told a recent seminar in London that investing in derivatives "allows you to achieve beta, but you need to understand the risks associated with the compilation of indices. If you hold a beta instrument and you're long and you're wrong, you're going to get caned."
For Theo Jeurissen, chief investment officer at Dutch metalworkers' union PMT, the solution is simple. He says he welcomes the emergence of derivatives, doesn't rule out investing in them, and is unfazed by the methodology that underlies them.
"If we're uncomfortable, we won't do it," he says. "If we don't understand it, or we don't trust the data, we won't invest."