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Understanding Asset Pricing for Real Estate Investments

Learn about the Fisher Equation and its application in valuing real estate assets. Understand the relationship between risk premiums, expected inflation, and returns on investments like bonds and property. Explore concepts like Gordon’s Growth Model and asset depreciation.

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Understanding Asset Pricing for Real Estate Investments

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  1. Asset pricing for real estate

  2. The Fisher Equation • Total required return comprises three parts R = l + i + RP • where • l is a reward for liquidity preference • i is expected inflation • RP is the risk premium

  3. The Fisher Equation and bonds R = l + i + RP • l is from required return on index-linked gilts: 1.5% • l + i is required return on conventional gilts: 4.0% • l is the real risk free rate (RFR) • l + i is the nominal risk free rate (RFN) • RFN = RFR + i and R = RFN + RP • Yield on conventional gilts - yield on index-linked gilts = expected rate of inflation (2.5%)

  4. Risk free rates/expected inflation • Yield on conventional bonds - yield on index-linked government bonds = expected rate of inflation (2.5%) • But are fixed interest government bonds risk free? • For pension funds, liabilities are real and fixed interest investments are risky • Then 4.0% = 1.5% + i + RP • Say 4.0% = 1.5%+ 2% + 0.5% • Inflation expectations are then 2%, not 2.5%

  5. Indexed or conventional bonds? • Indexed: 1.5% + inflation • Expected nominal return: 1.5% + 2% = 3.5% • Expected real return: 1.5% • Conventional: 4% + 0% • Expected nominal return: 4% + 0% = 4% • Expected real return: 4% - 2% = 2% • Available risk premium 0.5% on conventional

  6. Bonds or property? R = RFN + RP • Expected return on conventional gilts: 4% • Expected return on property and equities: 4% + RP • Expected return on property say 5-6% • This is the observed yield in 1935 • Observed yields in 1955 (bonds 5%, property and equities 4%) imply a negative risk premium • How can this ‘reverse yield gap’ happen?

  7. Gordon’s Growth Model • Assume constant rate of growth in nominal income (G) • Then: K = R - G • where k is an initial yield • R is the required return • G (nominal) = g (real) + i (inflation) • R = RFN + RP, so • K = RFN + RP - G

  8. Gordon’s Growth Model: example • Assume 0.5% real growth in rents • Assume expected inflation of 2% • Nominal growth (G) = g + i = 0.5% + 2% = 2.5% • Assume RP = 3%. What is the correct yield? K = RFN + RP – G =4% + 3% - 2.5% = 4.5%

  9. How depreciation affects property • Income growth is usually measured for hypothetical continually new properties • Forecasts are estimated in the same way • what will best office rents be in Paris in 2003? • what is the rate of growth for best buildings? • Real buildings wear out • refurbishment expenditure • rents decline relative to new • cap rates rise relative to new • UK evidence

  10. Depreciation : London offices (%) Average: 1.9%

  11. A property valuation model • Assume: • constant rate of depreciation (D) = 1% • RP for office property = 3% • G = long term average of 2.5% nominal (0.5% real) • Then: K = RFN + RP - G + D K = 4% + 3% - 2.5% + 1% = 5.5% • The correct yield is 5.5% • If the current yield is 5%: offices are expensive • If the current yield is 6%: offices are cheap

  12. Valuing asset classes

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