Risk premiums in cap rates of investment property.(Report)

ABSTRACT

This article reports the results of a study about the correlations and patterns over time between the composite elements of the initial yield in the prime office and retail property markets in the Netherlands, the United Kingdom (London), Belgium (Brussels), and Germany (Frankfurt). For this study, the determinant components are identified as the risk-free interest rate, inflation, and the risk premium. For the multiple regression analysis, these components are supplemented with dummy variables for property types and locations.

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Leased property is valued in the property market using gross or net initial yields, also known as capitalization rates or cap rates. In this article, gross yields and net yields are defined as income rates for the total real property interest. The capitalization rate is used to convert (net) operating income into an indication of the overall property price including buyer's costs.

Initial yield is an indicator and does not, in principle, provide an accurate measure of returns. Initial yields are derived from previous market transactions. The gross initial yield is regarded as being made up of several components, such as risk-free interest rate, expected income growth, risk premium, and operating costs. Stripping out the operating costs from the gross initial yield gives the net initial yield, which is made up of the remaining components, i.e., risk-free interest rate, expected income growth, and risk premium.

Valuation based on initial yields is a fairly crude method that does not take explicit account of factors such as risk, trends in cash flows, and changes in exit value. The initial yield includes the implicit future expectations of investors regarding real estate. These factors are made explicit in a discounted cash flow (DCF) calculation. The DCF approach also allows for the time value of money. A valuation expert, when valuing leased property, will first estimate the probable market value of the property using an initial yield approach. However, the recommendation as to whether or not a potential vendor should sell, or whether or not a potential buyer should purchase, requires a DCF approach. (1)

Initial Yield, DCF, and IRR