The Secular and Cyclic Determinants of Capitalization Rates: The Role of Property Fundamentals, Macroeconomic Factors, And Investor Sentiment

In this paper we revisit many studies that have attempted to explain the determinants of real estate capitalization rates. We introduce two new innovations. First we are able to identify two macroeconomic factors that greatly impact cap rates besides risk free treasury rates. These are the general corporate risk premium operating in the economy, and the amount of debt (liquidity) available. The addition of these factors greatly adds to the ability of previous models to explain the secular fall of cap rates in the last decade and the recent rise. In addition, we use innovative tests for “structural” shifts in the cap rate – even including all of these macro-economic factors. Our tests identify two distinct “periods” which we label “investor sentiment”. These were a period of negative sentiment in 1991-1996 and a period of positive sentiment from 2002-2007. Methodologically, our analysis uses a large and robust quarterly panel data set of 30 US metropolitan areas from 1980q1 through 2007q4. We compare models not only using traditional measures of within sample “fit”, but also examine how the models behave in in-sample “back test” forecasts.