The current real estate recession has created serious problems in the valuation of many income-producing properties. Appraisers and analysts have estimated market values of properties only to find that investors will not purchase the properties at those prices, or at any price that is acceptable to the seller. Property owners, particularly large institutions, have found themselves holding properties they would like to sell, but not at prices investors are willing to pay. Owners apparently are waiting for the market to return to more normal levels that will produce prices more consistent with replacement costs and their own investment.
While owners' reluctance to accept large losses may be understandable, the widely noted overvaluation of Resolution Trust Corporation (RTC) and other properties by appraisers and analysts during the early part of the real estate recession is not. We contend that this phenomenon results, at least in part, from analysts' failure to recognize the asymmetric effects of real estate cycles on risk-adjusted discount rates and capitalization rates. More specifically we argue that point estimates of future cash flows are less certain in overbuilt markets than in underbuilt markets, all else remaining the same. Thus, we believe that a given level of excess supply adds a larger amount to the required risk premium, and therefore to discount rates and capitalization rates, than a shortage of the same magnitude subtracts from the required risk premium.
CAPITALIZATION RATE COMPONENTS
As real estate counselors we know that capitalization rates are comprised of two parts--a return on investment and recapture of investment capital. The portion of the capitalization rate that represents return on investment is an interest rate or yield (usually called the discount rate) which compensates investors for the use of their capital. This discount rate must be high enough to compete with yields from other capital and financial investments of similar quality and risk. Often the discount rate is viewed as a rate that combines a riskless rate and an increment to compensate for the expected variability of real estate cash flows. The riskless rate usually is assumed to be the contemporaneous rate available on a U.S. Government security of comparable maturity.(1)
In discounted cash flow (DCF) analysis the discount rate is applied to projected (i.e., most likely) cash flows over a holding period. Accurate quantification of the risk component is crucial to the realistic valuation of a property. Whereas yields on government securities can be found quickly and easily, yields on real estate investments require judgments to be made about the comparability of a given investment alternative to other investments and about the effects of future events on the investment's cash flow stream. Sophisticated models have been formulated for identifying and measuring risk, e.g., the capital asset pricing model (CAPM) and the arbitrage pricing model (APM). However, these models do not foretell the future; they are limited by their use of historical data to make inferences about the appropriate size of the required risk premium. Moreover, the applicability of these standard finance models of risk quantification to real estate valuation has been questioned by numerous researchers, and, as a practical matter, it has been limited severely by the availability of reliable real estate return data. The counselor's or investor's judgment therefore must be applied to the direct quantification of risk or the application of the models for measuring risk.
The other component of the capitalization rate, recapture of capital, is a percentage that is added to the discount rate to reduce the amount that otherwise would be paid for an investment. This amount, when converted to an annual figure, is sufficient to repay the capital that has been invested over the asset's expected useful life or holding period. A sinking fund factor usually is used to represent capital recapture under the assumption that annualized amounts will accumulate at compound interest. …