CAPM Versus Expert Opinion: Do practitioners’ Perceptions Meet

Theory? Evidence from the Survey of Estonian Commercial Real Estate Market

Presentation at 22nd Annual European Real Estate Society Conference 24-27 June 2015 Istanbul, Turkey by

Kaia KaskEmail: kaia.kask@ut.ee

25th of June, 2015

Commercial real estate rates of returns in Estonia

Background and aim of the study• In valuing real estate or making decisions over

investments, various market-players are concerned with the problem, how to measure the expected rates of returns of targeted real estate asset.

• The current research aims to measure and compare the size of the commercial real estate market-based rates of returns in Estonia, using both direct and indirect assessment methods.

• The chosen methods were questionnaire conducted among market experts, from the direct methods, and modified CAPM from the indirect methods.25.06.2015 2

Introduction Theory CAPM Questionnaire Findings Discussion

Commercial real estate rates of returns in Estonia

Alternative methods for valuing the size of market-determined rates of return

25.06.2015 3

Measurement methods for discount rate

Indirect methods:c) Capital Asset Pricing Model (CAPM)d) Modified Capital Asset Pricing Model (mCAPM)e) Arbitrage Pricing Theory (APT)f) Fama and French Three Facor Modelg) Dividend Discount Model (DDM)h) Internal Rate of Return (IRR)i) Weighted Average Cost of Capital (WACC) j) Ramsey’ formulak) Other methods

Direct methods:a) Interviewsb) Questionnaire

Introduction Theory CAPM Questionnaire Findings Discussion

Commercial real estate rates of returns in Estonia

The applied formula of modified CAPM

• Long-term historical expected overall rate of return (E(Ri)) was assessed with the following formula:

RF – risk-free rate of return

βi – unleveraged (asset) beta

RPm – market risk premium

RPliq – liquidity risk premium

25.06.2015 4

liqmiFi RPRPβR)E(R

Introduction Theory CAPM Questionnaire Findings Discussion

Commercial real estate rates of returns in Estonia 5

Content of the components of CAPM in terms of Estonia

25.06.2015

Introduction Theory CAPM Questionnaire Findings Discussion

CAPM component and its data source Data description

Risk-free rate of return (EP data)• 10-year historical arithmetic average rate of return of German 10-year bond• 10-year historical arithmetic average market risk premium of USA• Country country risk premium of Estonia (based on the A1 reiting)

Unleveraged (asset) beta (www.damodaran.com)

• 10-year yearly average unleveraged beta coefficient of USA REITs

Liquidity premium (authors' calculations) • Based on roundtrip costs and average transaction period in Estonian market

Other risk premiums N/A

Market risk premium (www.damodaran.com)

Commercial real estate rates of returns in Estonia 6

CAPM structures based on historical average data

25.06.2015

E(RCAPMEE ) = 3.35%+0.733× (4,92%+ 1,28%) +0.8% = 8,69%

𝑘𝐴= 8,69%1−0.04 = 9,05%

Introduction Theory CAPM Questionnaire Findings Discussion

• 2010 survey:

• 2012 survey:

• 2015 survey:

Commercial real estate rates of returns in Estonia

The aim and assumptions of the questionnaire

• The aim of the questionnaire conducted among various real estate companies in Estonia was to ascertain the size of the market-based real estate rates of returns of typical commercial real estate assets (i.e., office, retail, warehouse buildings).

• The questionnaire targetted and the results of the questionnaire are applicable on a typical A-class commercial real estate assets assuming a view of a typical real estate investor in the market.

25.06.2015 7

Introduction Theory CAPM Questionnaire Findings Discussion

Commercial real estate rates of returns in Estonia 8

Background of the rates of returns questionnaire

25.06.2015

Introduction Theory CAPM Questionnaire Findings Discussion

No Time-frame Target groupSample size: number of real estate companies

Number of respondents

Response rate

1 Oct-Nov 2010investors, valuers, consultants, commercial banks

30 12 40%

2 Oct-Nov 2012investors, valuers, consultants, commercial banks

57 18 32%

3 June 2015valuers, consultants, commercial banks

29 8 28%

Commercial real estate rates of returns in Estonia 9

Object of the questionnaire• The conducted questionnaire covered both time and space:

i.e., the market experts were asked to give their opinion about different expected rates of returns for different commercial real estate assets in different regions over the long-term time-frame according to the following matrix:

25.06.2015

Introduction Theory CAPM Questionnaire Findings Discussion

Currently 1-2 years 3-5 years >5 years TallinnTartu/PärnuOther regions

RegionTime-frame

Commercial real estate rates of returns in Estonia 10

Overall long-term expected rate of return of commercial real estate in Estonia (%)

25.06.2015

2010 2012 2015CAPM 9,21 9,05 8,50Market experts:▪ median average 9,00* 9,00 9,5**▪ arithmetic average 9,46* 9,47 9,37**▪ std deviation 1,47 2,22 1,37

YearAssesment method

Introduction Theory CAPM Questionnaire Findings Discussion

* Excl. retail real estate assets

** Excl. investors

Commercial real estate rates of returns in Estonia

Conclusion and discussion• Both in theory and in practice one of the mostly suggested indirect assessment methods for

expected rate of return is CAPM. In terms of Estonia it is suggested to use modified CAPM.• However, based on current database, CAPM model allows little differentiation in terms of

small market and among its sub-markets considering different spaces and regions. Therefore, a questionnaire among market experts will give more diversified overview of the commercial real estate market.

• Both CAPM and expert opinion assessments are a certain synthesis from historical data, experiences and current economic situation and its future forecast, only the perspectives are different. While in terms of CAPM there is used indirect, market-based historical aggregated data, then a single expert opinion is based mainly on smaller-size portfolio-specific factors, which are aggregated together.

• In all questionnaires, due to the real estate market and sample peculiarity, the answers were biased towards Tallinn (i.e., capital city in Estonia) region and office buildings. The lowest rates of return were in Tallinn region and in office buildings.

• According to the results of the survey, it is possible to conclude that for a typical investor investing into a typical commercial real estate in Estonia, the average long-term expected overall rate of return is 9% (i.e., a rate of return that should cover the investors’ investment expenses together with the compensations for the taken risk), which is also comparable with an expected unleveraged equity rate of return.

25.06.2015 11

Introduction Theory CAPM Questionnaire Findings Discussion

Commercial real estate rates of returns in Estonia

Thank You for Your Attention!

25.06.2015 12