Determining Real Estate Betas for Markets and Property Types to Set Better Investment Hurdle Rates
Breidenbach, Manuel, Mueller, Glenn R., Schulte, Karl-Werner, Journal of Real Estate Portfolio Management
Corporate theory states that investment decisions are best made with a hurdle rate that is adjusted for each investment's risks. Although determining a real estate risk premium has been employed by many investors, calculating differential risk premiums within real estate are rare and usually proprietary. Many real estate investors, in fact, may not be aware of the actual risk associated with different property types or markets. Some investors have attempted to apply the Capital Asset Pricing Model (CAPM) for a private real estate investment using real estate investment trust (REIT) returns to develop betas for private investments. This paper compares property and market betas for both private real estate (using the NCREIF Index) and public real estate (using the NAREIT Index) so that investors can have a more accurate risk premium beta or benchmark for their decisions.
Many investors set only one investment hurdle rate for their private real estate investments and run the risk of overpaying for an asset that is exposed to higher levels of risk. Few adequate methods for calculating the risk-adjusted return on equity (required for a direct investment in a risky real estate asset) exist. This is caused by the common practice of purchasing real estate assets based on current "market determined" capitalization rates. These cap rates are driven by "what people are currently paying for real estate assets" and is partly a function of how much capital is chasing the real estate assets (Mueller, 1995).
The investment decision, however, should be independent of how much capital is chasing a particular asset. It may be better to sit on the sidelines for a year or two as opposed to buying a property at such a high price. Investors should have a required rate of return that is not driven by the perceived market rate. Part of the problem with applying a capital market valuation technique to a private inefficient market is the lack of available data. Another problem is that proxies such as publicly traded assets (real estate investment trusts, or REITs) may not be comparable to private market investments. Thus the key problem in applying the Capital Asset Pricing Model (CAPM) to private real estate is the calculation of a meaningful beta. As a result, there is a need for a model that will allow private real estate investors to accurately assess the risks that affect the cost of equity and use that model as a valuation alternative to the popular current investor surveys that may be misleading.
This study estimates a market risk premium for direct private real estate, and then develops a beta analysis by property type so that investors can differentiate risk premiums for each property type. It compares NCREIF property betas to NAREIT property betas and finds some similarities and some differences. It then develops a metro market beta for the office property type using a long-term data set that encompasses one full market cycle. This is important for investors because using NCREIF data, in order to arrive at beta values, allows the investor to calculate investment hurdle rates based on their relative risk. It may also allow for a comparison with current and historic cap rates and hence provides an alternative valuation tool to investor surveys.
The goal of this project is to use the CAPM, which is primarily used in the public capital markets for determining the required rate of return on private real estate equity. More specifically, this paper will concentrate on the development of meaningful beta proxies for the application to the CAPM, and examine current approaches used in the industry to calculate market risk premiums, as well as suggest improvements. Because real estate prices are currently high and real estate now has access to the public capital markets through REITs and CMBS, a CAPM will help private real-estate investors derive their real and adequate "required return" rates to make better decisions in their acquisitions and investments. …