Extending the Real Estate Pricing Model

Investment theory dictates that capitalisation rates for freehold real estate should be determined by the risk free nominal rate of return plus the risk premium less the expected growth rate, with an allowance for depreciation. The capitalisation rate will therefore vary depending on capital markets and a range of locational and physical characteristics, as well as leasing structures and tenant quality. The purpose of this micro-level study is to examine the pricing of commercial real estate investments focusing on the determination of capitalisation rates and the real estate attributes that influence the risk premium. In reality, capitalisation rates within market valuations are often determined by reference to direct comparison with other similar real estate investments, especially in mature, transparent markets with a depth of transactions. However, this process still requires some reconciliation of imperfect comparables. This study seeks to aid that process by identifying the attributes that drive the differences in capitalisation rates. This paper develops a risk framework that ranges from macro-economic influences to micro property-specific attributes. The framework is operationalised using a cross-sectional inter-temporal model, with a dataset of 497 real estate transactions in the London office sector from 2010 Q2 to 2012 Q3 that includes the new CoStar building quality rating launched in 2013. The findings are that the major influences on the variation in capitalisation rates are at the micro property-specific end of the risk scale. Submarket influences explain only 15% of the variation in capitalisation rates. Increases in the risk free rate, as measured by 10 year Government bonds, introduce a decrease in capitalisation rates; which suggests that over this period they were related to both a change in the risk premium and expected growth caused by changes in inflation expectations. The timing of the transaction has little influence as the study period saw stable yield levels. Specifying rental growth expectations within a modelling framework has proved problematic within other studies. Here, we identify a range of factors that, together with growth expectations, indicate investor concern for market quality. We adopt a submarket location rental change variable to identify the quality of the location that will ultimately drive rental growth. The analysis suggests better performing submarket locations are being recognised by investors through reduced capitalisation rates. Property-specific influences on capitalisation rates include the existence of mixed use offices with retail (lower capitalisation rates) or residential (higher capitalisation rates) and higher tenant covenant strength (lower capitalisation rates). We also explore the influence of transaction type, to include freehold or long leasehold tenure (freeholds have lower capitalisation rates). All these findings are as expected. Property-specific attributes that, surprisingly, fail to significantly impact on capitalisation rates include unexpired term to expiry; results for building quality are inconclusive although, when vacancy levels are high, some poorer quality buildings attract higher yields; single or multi letting; properties on corner plots; and sales of mixed ownership properties. However, some aspects of ownership are significant, principally those purchasing with international investment experience, whether from overseas or the UK, buy at lower capitalisation rates than UK investors with no international experience. The study employs a revealed preference method and a transaction based dataset that have not been used before to examine the pricing of commercial real estate investments. It breaks down and extends the traditional pricing model, adding further evidence of the drivers of capitalisation rates and investors’ risk preferences and behaviour