Mispricing income growth : exploring inefficiencies in commercial real estate pricing

This paper is an investigation into the relationship between real estate capitalization rates and income growth. The paper includes a cross-sectional analysis of approximately 25 markets in the United States. The paper analyzes apartment and office markets separately, for two different periods of time. Multi-variable regression techniques are used to explore the relationships between cap rates in different markets and rent growth, appreciation, and employment growth, as well as Liquidity and Supply Constraint factors. For this analysis, periods of time were chosen ranging from 1996 to 2002 so that subsequent rental growth, appreciation, and employment growth data was available. With this information, future growth of these variables is back tested. The results of the regressions are then compared to the theoretical relationships that should exist between cap rates and future income growth and appreciation. The results show that market pricing does not accurately price future income growth in a consistent manner. This provides significant evidence that the real estate capital market is inefficient in its pricing of assets in different markets based on the future rental behavior in individual markets. The last aspect of the thesis is the development of an investment strategy that capitalizes on the inefficiencies discovered in the analysis. The strategy enables the investor to make investments that should demonstrate superior risk-adjusted returns based on the space market fundamentals in individual markets.