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Asset pricing for real estate

Asset pricing for real estate. 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. The Fisher Equation and bonds. R = l + i + RP

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Asset pricing for real estate

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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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