Expected Returns and the Expected Growth in Rents of Commercial Real Estate

62 Pages Posted: 25 Jul 2005 Last revised: 10 Oct 2016

See all articles by Walter N. Torous

Walter N. Torous

Massachusetts Institute of Technology

Rossen I. Valkanov

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

Alberto Plazzi

Swiss Finance Institute; Universita' della Svizzera italiana

Date Written: March 8, 2010

Abstract

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, 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, Treasury bills, as well as commercial real estate.

Keywords: Cap rate, real estate, return predictability

JEL Classification: G12, R31

Suggested Citation

Torous, Walter N. and Valkanov, Rossen and Plazzi, Alberto, Expected Returns and the Expected Growth in Rents of Commercial Real Estate (March 8, 2010). EFA 2007 Ljubljana Meetings Paper, EFA 2005 Moscow Meetings Paper, AFA 2007 Chicago Meetings Paper, Available at SSRN: https://ssrn.com/abstract=564904

Walter N. Torous

Massachusetts Institute of Technology ( email )

Center for Real Estate and Sloan School
Cambridge, MA 02138
United States

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

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Universita' della Svizzera italiana ( email )

Via Buffi 13
CH-6900 Lugano
Switzerland

HOME PAGE: http://usi.to/mpy

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