Capitalization Rates, Discount Rates, and Net Operating Income: The Case of Downtown Chicago Office Buildings

Article excerpt

Executive Summary.

The value of commercial real estate is its net operating income divided by the capitalization rate set by the buyer. This study examines both components of value. It also examines the close relationship between capitalization rates and risk-adjusted discount rates used in commercial real estate investment. The paper includes an empirical study of the capitalization rates for 132 office building sales in downtown Chicago from 1996 to 2007. The capitalization rate is hypothesized to be a function of the classic capital asset pricing model variables and variables intended to capture the expectation that the real market value of the building will change. The empirical results are then used to provide estimates of the real risk-adjusted discount rates that were used by the investors in these properties. The paper also includes estimates of a model of net operating income for these buildings.

Institutional investors who would consider purchasing commercial real estate need to understand how competing investors evaluate properties. The basic real estate valuation equation is:


= Net Operating Income/Capitalization Rate.

This paper concentrates on these two fundamental determinants of value by providing econometric models of both variables that are based on the sales of office buildings in downtown Chicago. The potential buyer typically is provided with information that is sufficient (sometimes with considerable effort) to estimate net operating income (NOI) with reasonable accuracy. However, the buyer must also determine a capitalization rate to determine the value of the property and to formulate an offer price. As is shown below, the capitalization rate is closely related to the riskadjusted discount rate that the investor chooses. In particular:

Capitalization Rate = Discount Rate

- Expected Percentage Change in Value.

The risk-adjusted discount rate is the target rate of return set by the investor in commercial real estate, and usually is not observable to researchers. The capitalization rate is an observable variable, so this paper includes an empirical study of capitalization rates for office buildings that were sold in downtown Chicago from 1996 to 2007. The sample includes 132 transactions of large office buildings, some of which are among the most prominent structures in the nation. The study of capitalization rates is based on the capital asset pricing model (CAPM), supplemented by variables that real estate investors use as proxies for expected changes in the market value of an office building. These variables include features of the buildings and changes in the local market for office space. The study of capitalization rates permits us to infer the risk-adjusted discount rates used by the purchasers of these buildings. The results can be used in the opposite direction-to formulate a capitalization rate given the choice of a riskadjusted discount rate. This paper also includes an econometric study of NOI per square foot in these buildings.

This paper potentially is of value for institutional real estate investors for several reasons. First, the estimated econometric model of the capitalization rate reveals the factors that investors use to signal changes in the real value of commercial real estate. These include selected building characteristics and changes in local market conditions. Second, the results can be used to estimate the target real riskadjusted discount rates that this group of investors used when purchasing office buildings in downtown Chicago. The estimated equation for the real risk-adjusted discount rate in CAPM form is:

r = 3.953 + 0.205(Real Risk-free Rate)

+ 0.666(Real Mortgage Rate)

+ 0.008(Market Risk)

+ 0.008(Market Risk Lagged One Quarter).

For investors who do not borrow the equation would be:

r = 3.953 + Real Risk-free Rate

+ 0.03(Market Risk)

+ 0. …