2002 V30 3: pp. 385–414 REAL ESTATE ECONOMICS Optimal Valuation of Noisy Real Assets Paul D. Childs, ∗ Steven H. Ott, ∗∗ and Timothy J. Riddiough ∗∗∗ We study the optimal valuation of real assets when true asset values are unob- servable. In our model, the observed value cointegrates with the unobserved true asset value to cause serial correlation in the time series of observed val- ues. Autocorrelation as well as total variance in the observed value are used to calculate an efficient unbiased estimate of the true asset value (the time-filtered value). The optimal value estimate is shown to have three time-weighted terms: a deterministic forward value, a comparison of observed values with previously determined time-filtered values, and a convexity correction for incomplete in- formation. The residual variance measures the precision of the value estimate, which can increase or decrease monotonically over time as well as display a linear or nonlinear time trend. We also show how to revise time-filtered estimates based on the arrival of new information. Our results relate to work on illiquid asset markets, including appraisal smoothing, tests of market efficiency, and the valuation of options on real assets. Real asset value is typically estimated with error. This is because real assets have unique locational, physical, and contractual-relational characteristics that cannot be replicated—either physically or synthetically—by comparable assets. When these characteristics are priced, payoffs to the nontraded asset will also be difficult to replicate, thereby resulting in value estimation error (Case and Shiller 1989, Vandell 1991). Even a sale of the asset will be noisy because of liquidity and other private demands of investors, as well as bilateral bargaining outcomes in nondealer-intermediated markets (Quan and Quigley 1991). To understand the setting we have in mind, consider the valuation of commer- cial real estate that is unique in its location and physical design. The asset need not be highly unusual—only slight variations in location and physical design may result in a real asset whose characteristics are nonreplicable. Furthermore, the leasing contracts that determine the revenue flows to the asset are likely to be nonstandardized, with a set of tenants that vary in their space demands ∗ Carol Martin Gatton College of Business and Economics, University of Kentucky, Lexington, KY 40506-0034 or pchilds@uky.edu. ∗∗ Belk College of Business and Administration, University of North Carolina at Charlotte, Charlotte, NC 28223-0001 or shott@email.uncc.edu. ∗∗∗ Graduate School of Business, University of Wisconsin–Madison, Madison, WI 53706 or triddiough@bus.wisc.edu.