Direct Estimation of Factor Exposures from Appraisal Returns

Abstract

Valuation of alternative assets such as private equity and commercial real estate are appraisal based, rather than marked-to-market. Empirical studies show that appraisal based returns tend to be smoothed and exhibit strong autocorrelation, which creates a stale-pricing bias. In this paper, we have described the weaknesses of the current approaches to estimating risk factors for alternative assets. We then introduce a new method for estimating risk factor exposures which avoids these weaknesses. We also argue that misspecification of appraisal frequency may be the reason why factor sensitivities estimated from appraisal returns tend to be smaller than those estimated on underlying cash flows. Finally, we illustrate the application of the new method to popular measures of return for private equity and real estate.