Real estate is inherently quite different from equities, bonds, and cash. It is a physical asset rather than a financial asset. It is heterogeneous, indivisible, and immobile. It is a factor of production, like capital equipment and labor, and as such, it directly produces a return in the form of services. Its services can be sold but can be used/consumed only in one location. Owning and operating real estate involves operating and maintenance costs. All these factors contribute to making real estate illiquid and costly to transfer.
The heterogeneity, indivisibility, immobility, and illiquidity of real estate pose a severe problem for historical analysis. Properties trade infrequently, so there is virtually no chance of getting a sequence of simultaneous, periodic (say, quarterly) transaction prices for a cross section of properties. Real estate owners/investors must rely heavily on appraisals, rather than transactions, in valuing properties.
Real Estate Cycles
Boom: Increased demand will drive up property values and lease rates, which induces construction activity. This higher activity translates to stronger economic activity.
Bust: Falling demand leads to overcapacity and overbuilding, driving values and lease rates down. Because leases lock in tenants for longer terms and moving costs are high, excess supply can’t be quickly absorbed.
The capitalization rate, or cap rate, is a commercial real estate property’s earnings yield, and is calculated by dividing current net operating income (NOI) by the property value. It can be thought of as similar to the E/P ratio in equity valuation.
Note that lower cap rates are an indication of higher quality, lower risk properties. This is because the property value in the denominator is the primary driver. If cap rates are increasing, that means that property values are decreasing, or increasing at a rate slower then the NOI growth. These can be signs of lower quality or higher risk properties. In an E/P comparison, if earnings are increasing faster than price is, then the stock is severely undervalued, or there are other issues that make the stock less attractive. Perhaps the earnings growth is seen as unsustainable.
cap rate = E(Rre) – NOI growth rate
E(Rre) = Cap rate + NOI growth rate
During stable periods, the long-run NOI growth rate should be close to GDP growth. If an investor has a finite time period, the formula changes by subtracting from expected return the change in the cap rate:
E(Rre) = cap rate + NOI growth rate – %Δcap rate
Cap rates reflect long-term discount rates. As such, we should expect them to rise and fall with the general level of long-term interest rates, which tends to make them pro-cyclical (higher IR, higher cap rates). As rates rise, borrowing costs rise, discount factors rise and inflation may become targeted by the central bank. However, cap rates are also positively correlated with credit spreads, and credit spreads are countercyclical. As rates rise, credit spreads go down, and thus cap rates also have downward pressure. This is from less default risk. Thus the net effect on cap rates from rates and credit spreads is difficult to forecast out.
Risk Premiums on Real Estate
Real estate assets require several risk premiums to compensate for their higher risk. These include a term premium for holding long-term assets, a credit premium to compensate for the risk of tenant nonpayment, and an equity risk premium above corporate bond returns for the fluctuation in real estate values, leases and vacancies. Overall, the combined risk premium is higher than that of corporate bonds but lower than equities.
Public vs. Private Real Estate
Many institutional investors and some ultra-wealthy individuals are able to assemble diversified portfolios of direct real estate holdings. Investors with smaller portfolios must typically choose between limited, undiversified direct real estate holdings or obtaining real estate exposure through financial instruments, such as REIT shares. Assessing whether these alternatives—direct real estate and REITs—have similar investment characteristics is difficult because of return smoothing, heterogeneity of properties, and variations in leverage.
Long-Term Housing Returns
- Residential real estate had a higher (lower) real return than equities before (after) World War II.
- Residential real estate had a higher real return than equities in every country except Switzerland, the United Kingdom, and the United States over 1950–1980 but a lower return than equities in every country for 1980–2015.
- Residential real estate and equities had similar patterns—that is, a strong correlation—prior to the war but a low correlation after the war.
- Equity returns became increasingly correlated across countries after the war, but residential real estate returns are essentially uncorrelated across countries.