Living with Terminal Capitalization Rates: A Look at Real Estate Valuation Model Parameter Setting

This paper examines assumptions about future prices used in real estate applications of DCF models. We confirm both the widespread reliance on an ad hoc rule of increasing period-zero capitalization rates by 50 to 100 basis points to obtain terminal capitalization rates and the inability of the rule to project future real estate pricing. To understand how investors form expectations about future prices, we model the spread between the contemporaneously period-zero going-in and terminal capitalization rates and the spread between terminal rates assigned in period zero and going-in rates assigned in period N. Our regression results confirm statistical relationships between the terminal and next holding period going-in capitalization rate spread and the period-zero discount rate, although other economically significant variables are statistically insignificant. Linking terminal capitalization rates by assumption to going-in capitalization rates implies investors view future real estate pricing with myopic expectations. We discuss alternative specifications devoid of such linkage that align more with a rational expectations view of future real estate pricing.

Hotel Profit Implications from Rising Wages and Inflation in the U.S.

Macroeconomic models based on the Phillips Curve predict that as the unemployment rate declines toward the long-run, natural rate, the pace of wage and price growth accelerates and inflation rises.1 In this paper I analyze the profitability prospects for the U.S. hotel industry in today’s relatively volatile economic environment, keeping in mind the Phillips Curve’s general principle that inflation and employment have an inverse, but relatively stable short-term relationship. Although employment and economic growth in the U.S. have been uneven in recent months, the unemployment rate has declined to less than 5 percent, which many economists believe is close to the natural rate. Growth in wages and salaries, as measured by the Employment Cost Index, has concurrently been moving upward between 2.5 and 3.0 percent during the past 12 months. At the same time, general inflation remains below levels that might typically be expected this late in the cycle, although core inflation is bumping up against the Federal Reserve’s 2-percent target. If the inflation rate continues to move upward as predicted by Phillips Curve models (and encouraged by the Federal Reserve), rising labor costs and other expenses will exert downward pressure on U.S. business profits. Backward movement up the Phillips Curve (with greater inflation) coincides with an expanding economy. In that scenario, prices of goods and services also will rise in real terms if their supply cannot keep up with demand, and producers have the ability to raise prices (absent fixed-price contracts such as leases).