Academic journal article Journal of Urban and Regional Analysis

Rental Income and Cap Rates: A Comparison of the Lisbon and Porto Housing Markets

Academic journal article Journal of Urban and Regional Analysis

Rental Income and Cap Rates: A Comparison of the Lisbon and Porto Housing Markets

Article excerpt

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The real estate market is of vital importance to market economies on both provisional rent and investment levels. For example, the housing market is one of the most important markets in the United States (Carrillo 2013). Real estate is the first source of bank loan guarantees and a lifelong family investment, thereby contributing to social wellbeing. Gat (1994) points out that the housing market has a unique characteristic in that the owner of the asset normally occupies the property and acts simultaneously as an investor and consumer of the real estate asset. In certain markets as in Hong Kong there are large proportions of owner investors as opposed to owner occupiers (Xiao et al. 2007, Wood and Ong 2013). However, in this article the housing market is going to be understood in a wider context and it is not going to be analysed in either owner occupier or owner investor perspective.

Various property evaluation methods are commonly used: the comparative method, which is the most frequently used (Rebelo 2002, Alcázar Molina 2003, Pagourtzi et al. 2003, Nebreda et al. 2006), the cost method (Barlowe 1986), and the income method (Alcázar Molina 2003, Trojanek 2010). In the real estate appraisal, the income method evaluates lease agreements (Alcázar Molina 2003) and it verifies the configuration of rents, vacancy rates and the lease duration (Deng et al. 2003). This method also considers the application of a corresponding capitalisation rate (cap rate)1) (Ghysels et al. 2007, Baum et al. 2011).

Using the income method in the real estate appraisal requires the knowledge of techniques to estimate future rent projections and to update these as needed. Appraisers must understand the quality and duration of contracts, the costs related to the property (i.e. pertinent physical, functional and technological downgrades) and, naturally, the discount rate (Kwong and Leung 2000, Shimizu and Nishimura 2007). These elements serve the purpose of determining the market value of the real estate property.

In the real estate market, the price formation process is subject to frequent non-rational behaviour (Scheinkman and Xiong 2003, Hong et al. 2006, Hayunga and Lung 2011). As a result, market prices often experience large short-term changes, although, in the long run, prices tend to fluctuate around properties' fundamental value, thus representing the prices that truly matter to investors (Gordon and Shapiro 1956, Fu and Ng 2001, Grimes and Aitken 2010). The classical finance theory asserts that the law of financial risk and return is universal, as assets are normally traded in frictionless markets in which the investor sentiment is set aside (Markowitz 1952, Gat 1994). In this approach, property is seen as a productive asset capable of generating rent at a particular level of revenue. This perspective is applicable to both real estate and stock markets. The market value based on actual income is interpreted as the maximum sum that a knowledgeable investor is willing to pay for the acquisition of an asset, particularly related to its present occupancy rate and rental income (Ruback 1995). However, as Clayton et al. (2009) posit, this present standard value model has been unable to explain crashes in real estate asset prices. This clearly indicates that real estate market investors live in, and take advantage of, information asymmetry. For example, Tavares et al. (2013) conclude that real estate market brokers tend to give potential buyers information on positive externalities and tend to hold information on less positive characteristics of the quality of the dwelling or potential negative externalities.

Therefore, clear differences exist between real estate and stock markets as investor sentiment is not set aside in the former (Gat 1994, Hayunga and Lung 2011). Moreover, owners in real estate markets are simultaneously investors and consumers of the asset (Gat 1994). …

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