In this brave new world of assets being revalued, owing to rising interest rates, asset prices are under scrutiny. The high-end side of the real estate market, a mystery unto itself, is a particularly rich area of study. New research by Professor Toby Muhlhofer of SMU Cox and co-authors focuses on valuing illiquid assets, specifically commercial real estate and related securities. They developed an approach that complements existing methods of valuation.

In the research, the authors note prices of commercial real estate and related securities are not accurately reflecting economic fundamentals. The valuation of the real estate assets, based on appraisals, are considered “pseudo-market proxies” in academic terms. And ultimately, transaction prices often differ from their pricing “proxies” of appraisals. Interestingly, the research found that higher valued properties tend to be mis-priced more often.


Many large asset markets are plagued by illiquidity in which few trades occur. For example, commercial properties and leveraged loans—important asset classes in the portfolios of pension funds, banks, life insurance companies, and other institutional investors—trade infrequently and irregularly through time. That’s the textbook definition of a thinly-traded market.

Participants and asset owners in these illiquid markets are often required to approximate the market value of their financial positions on a regular basis. Commercial real estate, a $20.7 million market in the second quarter of 2021, according to the National Association of Real Estate Investment Trusts, is “approximately the size of the stock market,” notes Muhlhofer. Appraisals, considered informed opinions, are used as proxies for valuing real estate assets. “As finance people, we’re always interested in obtaining the correct price data, and therefore returns data, to understand an asset’s value which is someone’s investment.

“The problem in determining an asset’s price is that the only true observed price is if a buyer and seller shake hands, right?” Muhlhofer asks rhetorically. “If we actually talk about what a property may be worth, that’s not useful information because somebody needs to write a check, somebody needs to receive a check, and relinquish the asset. Then we know what the price of that asset is.” The research helps answer the question: do the proxies of appraisals for commercial real estate and matrix prices for the related bonds actually reflect economic fundamentals?

Importantly, transactions in commercial real estate are sparse and therefore thinly traded. Very few downtown Dallas office tower buildings change hands each year, for example. In comparison, Apple’s stock trades thousands of times per day, offering deep liquidity. The research studies the cash flows of commercial real estate assets and commercial mortgage real estate bonds (CRMB) to determine how well pseudo-market proxies are reflecting the value of these assets.

Left on the table

“We find that the commercial real estate appraisals where humans are involved tend to have a kind of a large cross-sectional scatter and there are individual misses on certain buildings,” Muhlhofer says. In the aggregate, at an index level, the estimates get much better. “We have evidence, however, that there are some substantial misses on some very large assets, which from a finance perspective is a problem,” he adds. The dollar amounts of large assets play a larger role than smaller assets, thus misrepresenting the market. After the financial crisis, in matrix prices for bonds, which are algorithmically-generated, mispricing was found in riskier bond tranches. Interestingly, they were more accurate before and during the financial crisis.

According to Muhlhofer, the valuation “misses” are money being left on the table. In fact, there are big misses, or mis-pricings, on large properties, which has implications for institutional investors such as pension funds and insurance firms. They tend to have significant positions in these long-lived types of assets in their investment portfolios.

In the research, the pseudo-market proxies, ie., informed opinions or appraisals, can be improved by adding incremental information that the authors’ methodology provides. Often extensive information is available about the asset’s cash flows. Cash flow streams hold one key in their methodology. The combination of the authors’ model, alongside the market’s proxies, allows investors to better allocate investment capital. At both individual and portfolio levels, they found that appraisals failed to incorporate economic factors, and especially so for higher valued properties.

Real opportunity

The complexity in valuing real estate assets allows for an interesting comparison with real estate investment trusts (REITs). “Essentially, REITs allow the investor to trade real estate cash flows with the liquidity and pricing transparency of the stock market,” notes Muhlhofer. But the smart money is offered opportunities through this information asymmetry. “That’s the beauty of real estate,” he says. “It’s this lack of transactions, and thus transparency, which leads to th mispricing that allows for the potential value add of smart investors or management.”

Muhlhofer tells his students that real estate is a place where you can make money. “You have to understand the processes and the fundamentals,” he adds, “but compared to increasingly efficient markets, like the stock market, there’s opportunity.”

Real estate redevelopment, transforming that which is old into the new, is an area in which good active management can truly add value, Muhlhofer notes. “Redeveloping under-utilized or mis-placed real estate assets can create value for everybody.” Real estate offers the space that encompasses the many activities of people’s lives.

The paper “Assessing Proxies for Market Prices of Thinly Traded Assets with Scheduled Cash Flows” by Tobias Muhlhofer of Southern Methodist University’s Cox School of Business, Walter Boudry of SMU, Crocker Liu of Cornell University, and Walter Torous of Massachusetts Institute of Technology (MIT) is a MIT Center for Real Estate working paper.

Written by Jennifer Warren.