Economic and Competitive Factors on Real Estate

Economic and Competitive Factors on Real Estate

Forecasting Real Estate Returns

This reading focuses on directly held, non-levered, income-producing real estate. REITs are covered in further detail in other sections. Directly held real estate is distinct from other asset classes because it is immobile, illiquid, indivisible, and costly to transfer.

Historical Real Estate Returns

Historical real estate returns have been notoriously hard to work with. Much of the usable data comes from appraisals rather than sales. These often happen infrequently. The fact that real estate trades infrequently causes a smoothing effect, which understates true volatility. To deal with this, some analysts use time series models.

Real Estate Cycles

Property values, rents, and occupancy rates are the fundamental factors driving real estate investment returns. There is a great deal of variety in the composition of real estate compared to most other assets, so it can be challenging to predict which properties may be affected by economic events and to what degree. Most real estate does, however, experience a boom-bust cycle similar to the overall economy. Optimistic projections can lead to over-building and over-leveraging, leading to contractions.

Capitalization Rates

Capitalization rates are the standard metric for valuing real estate investments. Higher cap rates mean that a property produces higher income than its value. The equation setup is similar to the constant growth model and the Grinold-Kroner Model for equities, only without the share buyback aspect.

$$ \text{Cap rate} =\frac {\text{Current period net operating income} }{ \text{Property value}} $$

$$ \text{Expected return} = \text{Cap rate} + \text{NOI growth rate} $$

Generally, commercial real estate’s long-run, steady-state NOI growth rate should be reasonably close to the GDP growth rate.

The Risk Premium Perspective on Real Estate Expected Return

Real estate is often thought of as a hybrid asset class. As one of the longest-lived assets, real estate should earn a term premium; the longer the investment period, the higher the return. This makes real estate investments similar to bonds. Another bond-like characteristic is the exposure landlords have to tenant credit quality.

On the other hand, similar to equities, real estate returns are pro-cyclical, which implies the need for a robust equity-risk premium (relative to corporate bonds). Combining bond-like characteristics with equity-like characteristics infers that real estate should earn a risk premium between bonds and stocks.

Real Estate in Equilibrium

Therefore, real estate as an asset class is highly illiquid and should merit a liquidity risk premium. Local economic conditions will also likely affect Direct real estate ownership. This makes using an equilibrium model such as the Singer-Terhaar Model appropriate. Before introducing such a model, an analyst should also consider the smoothing effect of the data.

Public vs. Private Real Estate

Commercial real estate differs in public and private sectors, although the extent of the differences is not fully understood. Public real estate investment is mainly in the form of REITs and REOCs. These traded securities allow investors with smaller portfolios to access diversification via publicly traded instruments. This characteristic makes REITs behave more like stocks in the short term but more like real estate in the long term.

Long-term Housing Returns

Residential real estate accounts for approximately 75% of the total value of developed properties globally. Most individuals’ homes are their primary, perhaps only, real estate investment.

A relatively new database provides a global perspective on the long-term performance of residential real estate (housing), equities, and bonds. The database spans 1870–2015 and 16 countries. Jordà, Knoll, Kuvshinov, Schlaich, and Taylor (2017) found that residential real estate was the best-performing asset class over the entire sample period, with a higher real return and much lower volatility than equities. The findings come with a caveat: these returns vary by country and show differences before and after World War II, indicating a cautious interpretation is necessary.

Question

Two real estate investors are looking for a property near a beach in Mexico. The first investor finds a property with a cap rate of 7%, while the second one finds a property with a cap rate of 13%. Which of the following statements is the most accurate?

  1. Property #1 has better growth prospects.
  2. Property #1 is less valuable than net operating income (NOI).
  3. Property #2 has a higher net operating income (NOI) than property value.

Solution

The correct answer is C.

Recalling the formula for the capitalization rate:

$$ \text{Cap rate} =\frac {\text{Current period net operating income} }{ \text{Property value}} $$

A higher cap rate means a higher NOI relative to property value. Thus,  property #2 is more profitable and thus deserves a higher capitalization rate than property #1.

A and B are incorrect. They do not accurately reflect the relationship between cap rate, growth prospects, and net operating income (NOI).

Choice A states that “Property #1 has better growth prospects,” but the cap rate does not directly measure growth prospects. Instead, it measures the expected rate of return on an investment property based on its net operating income and current market value.

Choice B states, “Property #1 is less valuable than net operating income (NOI).” Still, this statement does not make sense because the cap rate is a ratio of NOI to property value, not a comparison of the two.

Asset Allocation: Learning Module 2: Capital Market Expectations – Part 2 Forecasting Asset Class Returns; Los 2(e) Explain how economic and competitive factors can affect expectations for real estate investment markets and sector returns

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