Joseph L. Pagliari, Jr. Clinical Professor of Real Estate
May 2, 2013
Real Estate Research Institute
Discussion of: “Finding Cap Rates:
A Property Level Analysis of Commercial Real Estate Pricing”
1 An Outline of My Thoughts
OVERVIEW: – METHODOLOGY: My focus will not be on technique
– APPLICATIONS: My focus will be on theory & implementation: – income v. cash flow, – term structure of leases, – growth in income (&/or cash flow), – other fixed effects, – instrumental variables, and – investor sentiment.
– CONCLUSION: Less a criticism, more an emphasis on future research avenues
2 Better Intuition about Gordon’s Dividend Discount Model
SUBJECT PAPER: – RESTATEMENT OF GORDON MODEL:
DISCUSSANT COMMENT: – CORRECTION: However, Gordon’s model is based on cash flows:
NOIt ≠ Cash Flowt
– MODIFICATION : Would like to see the “cap ex” effects on yields
1 1Cap Ratet tt t t t
t t t
NOI NOIP r gr g P
+ += ⇒ = = −−
1 1 1 1Cash Flow Yieldt t t tt t t t
t t t
NOI CapEx NOI CapExP r gr g P
+ + + +− −= ⇒ = = −
−
3 Cap Rates → Cash-Flow Yields
• The level and volatility of cap ex ought to be included as a priced factor. • For example, apartments have a very different “cap ex” behavior:
An Illustration:Conversion of Cap Rates to Cash Flow Yield
Estimated
Estimated Dividend Estimated
Capitalization Pay-Out Cash Flow
Property Type Rate (1) Rate (2)(3) Rate (4)
Apartments 6.11% 82.5% 5.15%
Industrial 7.63% 66.0% 4.70%
Office 7.27% 61.8% 4.48%
Retail 7.01% 75.0% 5.35%
All 6.92% 70.4% 4.87%
(1) Source: Real Capital Analytics, "Month in Review," February 2013.
(3) Source: NCREIF and author's calculations.
(4) Represents the product of the capitalization rate and the dividend pay-out ratio.
(2) Represents typical portion of NOI converted to cash flow. The difference represents "cap ex" (i.e. , tenant improvements, leasing commissions and capital improvements.
4 A Small Aside: “Cap Rates” Are Ambiguous in Practice
– An aside: Variety of cap rate definitions in practice: • trailing v. forward income, • without v. with reserves ⟵ ≈ cap ex smoothing • “stabilized” v. non-stabilized, • etc.
– How does your definition of “cap rate” relate to practice?
5 An Outline of My Thoughts
OVERVIEW: – METHODOLOGY: My focus will not be on technique
– APPLICATIONS: My focus will be on theory & implementation: – income v. cash flow, – term structure of leases, – growth in income (&/or cash flow), – other fixed effects, – instrumental variables, and – investor sentiment.
– CONCLUSION: Less a criticism, more an emphasis on future research avenues
6 Better Intuition about Gordon’s Dividend Discount Model
SUBJECT PAPER: – RESTATEMENT OF GORDON MODEL:
DISCUSSANT COMMENT: – WARNING: However, Gordon’s model is based on cash flows growing
at a constant rate. – This may be plausible for apartments, hotels and portfolios. – This may be implausible for individual industrial, office and
retail properties.
– MODIFICATION : What about lease maturity date(s)?
1 1Cap Ratet tt t t t
t t t
NOI NOIP r gr g P
+ += ⇒ = = −−
8 Consider a Simple Example of a One-Time Rent Bump (continued)
Lease Payments
CFN
CF0
N Time
( )N
N
kk
CFCF
2
2
0
1+
−
1
0
kCF
Illustration of INCOME-DIFFERENTIAL Model: Viewed as Two Perpetual Annuities | One Longer-Dated than the Other
9 As Lease Maturity Dates Vary, “Cap Rates” Vary
– Consider: 10 < N ≤ 60 • Must solve for cap rate, given 10 < N ≤ 60 • where: P0 (= $100), rt (= 10%) and gt (= 2%) are constant across all
combinations
– Consider the two limiting cases: – 1) Constant rent growth:
• Cap rate = rt – gt = .10 - .02 = .08
– 2) No rent growth (N → ∞ ) • Cap rate = rt – gt = .10 - 0 = .10
10 As Lease Maturity Dates Vary, “Cap Rates” Vary (continued)
– Cap Rates vary purely as a function of N ; all other factors are held constant
11 An Outline of My Thoughts
OVERVIEW: – METHODOLOGY: My focus will not be on technique
– APPLICATIONS: My focus will be on theory & implementation: – income v. cash flow, – term structure of leases, – growth in income (&/or cash flow), – other fixed effects, – instrumental variables, and – investor sentiment.
– CONCLUSION: Less a criticism, more an emphasis on future research avenues
1 1 1 1Cash Flow Yieldt t t tt t t t
t t t
NOI CapEx NOI CapExP r gr g P
+ + + +− −= ⇒ = = −
−
12 What About Growth?!?!
– Clearly, cap rates can be greatly influenced by expected growth in future cash flows:
– Cap rates (or cash-flow yields) are positively correlated with returns – Longstanding story in mainstream finance:
Higgledy-piggledy growth (Little, 1962) Value v. growth (Lakonishok, Shleifer & Vishny, 1994)
• Real estate work in this area as well: • e.g., Plazzi, Torous & Valkanov (2011 RERI paper)
– Like cap ex, my concern is that a richer story can be produced by
empirically examining the pricing of the growth factor.
13 Let’s Explore Growth: Too Much of a Good Thing?
Atlanta
Austin
Baltimore
Boston
Charlotte
Cincinnati
Dallas
Denver
Detroit
Houston
Kansas City
Miami
Minneapolis
Nashville
New York
Orlando
Phoenix
Portland, OR
Riverside
Salt Lake City
San Diego
San Francisco
Seattle
St. Louis
Tampa
Washington, D.C.
y = -0.1281x2 + 0.3918x + 0.1456R² = 0.2465
(0.40)
(0.20)
-
0.20
0.40
0.60
0.80
-0.5 0 0.5 1 1.5 2 2.5 3 3.5 4
Shar
pe R
atio
Annual Household Formation(%)
Illustration of Relationship between Metro-Area Growth & Risk-Adjusted Returns:Household Formation v. Apartment Risk-Adjusted Return for the Ten-Year Period Ended in 2011
14 An Outline of My Thoughts
OVERVIEW: – METHODOLOGY: My focus will not be on technique
– APPLICATIONS: My focus will be on theory & implementation: – income v. cash flow, – term structure of leases, – growth in income (&/or cash flow), – other fixed effects, – instrumental variables, and – investor sentiment.
– CONCLUSION: Less a criticism, more an emphasis on future research avenues
15 What About Major v. Non-Major Markets?
• Prices and cap rates can significantly differ by quality
60%
70%
80%
90%
100%
110%
120%
130%
140%
$50
$75
$100
$125
$150
$175
$200
$225
$250
2000 2002 2003 2005 2006 2007 2009 2010 2011
Rat
io o
f N
on-M
ajor
to M
ajor
-Mar
ket A
sset
Val
ues
(Unl
ever
ed) A
sset
Val
ues f
or C
ore
Prop
ertie
sAsset Appreciation in Major v. Non-Major Markets
From December 2000 through January 2013
Major Markets
Non-Major Markets
Ratio of Non-Major to Major Markets
Source: Real Capital Analytics and Instructor's calculations.
16 An Outline of My Thoughts
OVERVIEW: – METHODOLOGY: My focus will not be on technique
– APPLICATIONS: My focus will be on theory & implementation: – income v. cash flow, – term structure of leases, – growth in income (&/or cash flow), – other fixed effects, – instrumental variables, and – investor sentiment.
– CONCLUSION: Less a criticism, more an emphasis on future research avenues
17 The Collapse of the CMBS Market
$0
$50
$100
$150
$200
$250
$300
$350
'95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 1st 4 Mos '12
1st 4 Mos '13
Annual CMBS Issuance ($ billion)
Non-U.S. CMBS
U.S. CMBS
Source: Commercial Mortgage Alert
18 How Can the CMBS Collapse Co-Exist with Falling Cap Rates?
Sources: NCREIF and instructor’s calculations.
2.5%
3.5%
4.5%
5.5%
6.5%
7.5%
8.5%
9.5%
$0
$50
$100
$150
$200
$250
$300
$350
$40019
78
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Cap
italiz
atio
n R
ate
Mar
ket V
alue
and
Res
cale
d N
OI
NCREIF Property Index: Market Values, Rescaled NOI and Capitalization Rates Based on a $100 Investment for the Period 1978 through 2012
Capitalization Rates (Right Axis) Market Values Rescaled NOI Average Capitalization Rate (Right Axis)
19 Pro-cyclical CMBS Underwriting Standards?
Source: Moody’s, “U.S. CMBS Review,” 3rd Quarter 2012.
• Another case of “here we go again”?
21 An Outline of My Thoughts
OVERVIEW: – METHODOLOGY: My focus will not be on technique
– APPLICATIONS: My focus will be on theory & implementation: – income v. cash flow, – term structure of leases, – growth in income (&/or cash flow), – other fixed effects, – instrumental variables, and – investor sentiment.
– CONCLUSION: Less a criticism, more an emphasis on future research avenues
22 Better Intuition about Gordon’s Dividend Discount Model
SUBJECT PAPER: – EXPANSION OF GORDON MODEL:
where: st = investor sentiment and mt = mortgage supply DISCUSSANT COMMENT: – QUESTIONS:
• Isn’t “sentiment” subsumed in rt ? • Is it “sentiment” or is it:
• “return-chasing” (Jensen’s ex post α) behavior? • “momentum-chasing (ala Jegadeesh & Titman)?
( ) ( )1 1Cap Rate+ += ⇒ = = − + +−
t tt t t t t t
t t t
NOI NOIP r g f s g mr g P
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