The Capitalization Rate of Commercial Properties and Market Returns

This study develops a model of real estate cap rates that draws on the weighted average cost of capital (WACC) theory and the capital asset pricing model (CAPM) in the finance literature. The model indicates cap rates are determined by debt and equity spreads. The debt spread is the risky debt rate less the risk-free rate, and the equity spread is the return on the market less the risk-free rate. The empirical results support the importance of both spreads; however, cap rates respond with significant adjustment lags to changes in capital market spreads. Our findings support the widely held belief that real estate markets are information inefficient and segmented from the national capital market.