The determinants of capitalisation rates: evidence from the US real estate markets

Abstract

PurposeEstablishing the strength of a novel variable–mortgage debt as a fraction of US gross domestic product (GDP)–on forecasting capitalization rates in both the US office and multifamily sectors.Design/methodology/approachThe authors specifies a vector error correction model (VECM) to the data. VECM are used to address the nonstationarity issues of financial variables while maintaining the information embedded in the levels of the data, as opposed to their differences. The cap rate series used are from Green Street Advisors and represent transaction cap rates which avoids the problem of artificial smoothness found in appraisal-based cap rates.FindingsUsing a VECM specified with the novel variable, unemployment and past cap rates contains enough information to produce more robust forecasts than the traditional variables (return expectations and risk premiums). The method is robust both in and out of sample.Practical implicationsThis has direct implications for governmental policy, offering a path to real estate price stability and growth through mortgage access–functions largely influenced by the Fed and the quasi-federal agencies Fannie Mae and Freddie Mac. It also offers a timely alternative to interest rate-based forecasting models, which are likely to be less useful as interest rates are to be held low for the foreseeable future.Originality/valueThis study offers a new and highly explanatory variable to the literature while being among the only to model either (1) transactional cap rates (versus appraisal) (2) out-of-sample data (versus in-sample) (3) without the use of the traditional variables thought to be integral to cap rate modelling (return expectations and risk premiums).

Cap Rates as a Function of Real Economic Growth

“…We posit that the reason some studies find interest rates important to real estate prices (Aizenman and Jinjarak 2009) is because in certain contexts they are very impactful (when they exceed GDP growth). Moreover, the reason other studies find interest rates to be unimportant to real estate values (Quan and Titman (1997); Larriva and Linneman (2021)) is because often, they are not (when they are lower than GDP growth). Our model, in addition to showing when inflation is relevant to commercial real estate growth, simplifies the state of research which is trending toward more and more complex methodologies (Christopoulos et al 2020) to explain a relationship which may be simpler than previously thought.…”

“…The second lens by which to view the research is through methodology selection, as documented by Larriva and Linneman (2021). The authors divide the research into simple time series methods, multivariate time series, and machine learning methods.…”

“…Supporters suggest that inflation rates are inversely related to cap rates either via real rates, the weighted average cost of capital, or increased borrowing costs. More recent work suggests the relationship is not significant (Larriva and Linneman 2021).…”

The financial risk of real estate combined factor analysis with grey prediction in Liaoning Province

“…Lee et al [ 16 ] used Portfolio Expected Loss (PEL α) and Portfolio Upper Loss (PUL α) to measure the financial risk of real estate and divide it into five quality levels in order to achieve better risk aversion effect. Larriva and Linneman [ 17 ] completed the real estate financial risk study by using the proportion of mortgage debt to the US GDP. The results showed that the future interest rate would remain at a low level and the real estate financial risk would remain at a low level.…”