Expected returns and expected growth in rents of commercial real estate

Commercial real estate expected returns and expected rent growth rates are time-varying. Relying on transactions data from a cross-section of U.S. metropolitan areas, we find that up to 30% of the variability of realized returns to commercial real estate can be accounted for by expected return varia...

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Bibliographic Details
Published in:The Review of financial studies 2010-09, Vol.23 (9), p.3437-3468
Main Authors: Plazzi, Alberto, Torous, Walter, Valkanov, Rossen
Format: Article
Language:English
Subjects:
Commercial property
Expectation
Forecasts
Investment returns
Measurement
Portfolio management
Real estate
Rent
U.S.A
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Summary:Commercial real estate expected returns and expected rent growth rates are time-varying. Relying on transactions data from a cross-section of U.S. metropolitan areas, we find that up to 30% of the variability of realized returns to commercial real estate can be accounted for by expected return variability, while expected rent growth rate variability explains up to 45% of the variability of realized rent growth rates. The cap rate -- that is, the rent-price ratio in commercial real estate -- captures fluctuations in expected returns for apartments and retail properties, as well as industrial properties. For offices, by contrast, cap rates do not forecast (in-sample) returns even though expected returns on offices are also time-varying. As implied by the present value relation, cap rates marginally forecast office rent growth but not rent growth of apartments, retail properties, and industrial properties. We link these differences in in-sample predictability to differences in the stochastic properties of the underlying commercial real estate data-generating processes. Also, rent growth predictability is observed mostly in locations characterized by higher population density and stringent land-use restrictions. The opposite is true for return predictability. The dynamic portfolio implications of time-varying commercial real estate returns are also explored in the context of a portfolio manager investing in the aggregate stock market and Treasury bills, as well as commercial real estate. [PUBLICATION ABSTRACT] Reprinted by permission of Oxford University Press
ISSN:0893-9454