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.

Findings from the 2015 Institutional Real Estate Capital Allocations Monitor

Since 2013, the Baker Program in Real Estate and Hodes Weill & Associates have co-sponsored the Institutional Real Estate Capital Allocations Monitor (the “Allocations Monitor”). The Allocations Monitor was created to conduct a comprehensive annual assessment of institutional allocations to real estate investments through analyzing trends and collecting survey responses of institutional portfolios and allocations by region, type, and size of institution. The Allocations Monitor reports on the role of real estate investments in institutional portfolios, and the impact of institutional allocation trends on the investment management industry.