Valuation in the US Commercial Real Estate

37 Pages Posted: 16 Oct 2006  

Eric Ghysels

University of North Carolina Kenan-Flagler Business School; University of North Carolina (UNC) at Chapel Hill - Department of Economics

Rossen I. Valkanov

University of California, San Diego (UCSD) - Rady School of Management

Alberto Plazzi

USI-Lugano; Swiss Finance Institute

Date Written: October 2006

Abstract

We consider a log-linearized version of a discounted rents model to price commercial real estate as an alternative to traditional hedonic models. First, we verify a key implication of the model, namely, that cap rates forecast commercial real estate returns. We do this using two different methodologies: time series regressions of 21 US metropolitan areas and mixed data sampling (MIDAS) regressions with aggregate REITs returns. Both approaches confirm that the cap rate is related to fluctuations in future returns. We also investigate the provenance of the predictability. Based on the model, we decompose fluctuations in the cap rate into three parts: (i) local state variables (demographic and local economic variables); (ii) growth in rents; and (iii) an orthogonal part. About 30% of the fluctuation in the cap rate is explained by the local state variables and the growth in rents. We use the cap rate decomposition into our predictive regression and find a positive relation between fluctuations in economic conditions and future returns. However, a larger and significant part of the cap rate predictability is due the orthogonal part, which is unrelated to fundamentals. This implies that economic conditions, which are also used in hedonic pricing of real estate, cannot fully account for future movements in returns. We conclude that commercial real estate prices, at least at an aggregate level, are better modeled as financial assets and that the discounted rent model might be more suitable than traditional hedonic models, at least at an aggregate level.

Keywords: Real Estate, MIDAS, Cap rate, Predictive regression

JEL Classification: G12, L85

Suggested Citation

Ghysels, Eric and Valkanov, Rossen I. and Plazzi, Alberto, Valuation in the US Commercial Real Estate (October 2006). Available at SSRN: https://ssrn.com/abstract=937800 or http://dx.doi.org/10.2139/ssrn.937800

Eric Ghysels

University of North Carolina Kenan-Flagler Business School ( email )

Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States

University of North Carolina (UNC) at Chapel Hill - Department of Economics ( email )

Gardner Hall, CB 3305
Chapel Hill, NC 27599
United States
919-966-5325 (Phone)
919-966-4986 (Fax)

HOME PAGE: http://www.unc.edu/~eghysels/

Rossen Valkanov (Contact Author)

University of California, San Diego (UCSD) - Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States
858-534-0898 (Phone)

Alberto Plazzi

USI-Lugano ( email )

Via Buffi 13
CH-6900 Lugano
Switzerland

Swiss Finance Institute ( email )

c/o University of Geneve
40, Bd du Pont-d'Arve
1211 Geneva, CH-6900
Switzerland

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