Commercial Real Estate Rental Index: A Dynamic Panel Data Model Estimation

Using the actual quarterly rental income generated in the years between 2001 and 2010 by over 9,000 NCREIF commercial properties, we construct a commercial real estate rental index and estimate the time series properties (e.g., mean‐reversion speed and volatility) of market‐wide rental growth using a dynamic panel data model. The dynamic panel data model has several advantages over a standard hedonic regression. In addition, we incorporate age effects into our panel data model, and by doing so we correct the age bias in the repeated sales method and in the simple average method. Our estimates show that rental growth is cyclical but it generally lags behind broader economic growth. Surprisingly, the long‐term average rental growth is significantly lower than what is usually perceived, and the volatility of rental growth can be significantly under estimated when the conventional methods are adopted. We also find significant cross‐property type and cross‐region variations in the rental adjustment process. In contrast to the existing literature, we find a strong negative relation between rental growth and cap rate, and that this relation is significantly stronger than that between NOI growth and cap rate. Finally, we establish an empirical relation between price return and rental growth in the commercial real estate market.     

On the Value of Environmental Certification in the Commercial Real Estate Market

A significant part of the global carbon externality stems from the real estate sector. Environmental certification is often hailed as an effective means to resolve the information asymmetry that may prevent markets from effectively pricing the energy performance of buildings. This study analyzes the adoption and financial outcomes of environmentally certified commercial real estate over time. We document that nearly 40% of space in the 30 largest U.S. commercial real estate markets holds some kind of environmental certification in 2014, as compared to less than 5% in 2005. Tracking the rental growth of 26,212 office buildings, we measure the performance of environmentally certified real estate over time. We document that certified office buildings, on average, have slightly higher rental, occupancy and pricing levels, but do not outperform non‐certified buildings in rental growth over the 2004–2013 period. Further performance attribution analysis indicates that local climate conditions, local energy prices and the extent of certification lead to significant heterogeneity in market pricing. On aggregate, these findings provide some evidence on the efficiency of the market in the adoption and capitalization of environmental characteristics in the commercial real estate market.     

Office Rent Processes: The Case of U.S. Metropolitan Markets

This paper synthesizes elements of the traditional and contemporary theory of real estate markets to formulate an empirical framework for exploring metropolitan office rent processes. Such a framework is then applied to the analysis of office rents across 18 U.S. office markets during 1986–1995. The empirical results underscore the sluggishness of rental adjustments, highlight the extent of rental disequilibria across markets, and uncover the role of office employment factors (such as size, diversity, spatial organization, growth rates, and volatility), construction costs, interest rates, amenities, and zoning in shaping interarea differentials in the equilibrium component of office rents.     

A Regime‐Switching Approach to Modeling Rental Prices of U.K. Real Estate Sectors

This article uses regime‐switching models of the threshold type to analyze the adjustment process of rental prices for three U.K. commercial real estate sectors over the period 1974–2008. The nonlinear models outperform their linear counterparts in in‐sample fit. Their out‐of‐sample forecasting ability is better whenever the corresponding linear models contain a significant amount of neglected nonlinearity. Regime switches are triggered when the growth rates of rental price exceed certain threshold levels. For the industrial and retail sectors such regime switches occur in situations of strong excess demand, for the office sector they occur when there is strong excess supply.     

Twenty Years of the NCREIF Property Index

This study overviews the performance of the NCREIF Property Index, by property type, over the twenty-year period ended in 1998. More exactly, performance is analyzed from the perspective of the fundamental sources of return: initial earnings yield, dividend payout ratios, earnings growth, shifts in capitalization rates and other (less significant) effects. (While this approach is here applied to private real estate equities, nothing precludes its application to a variety of other investment classes.) Our results indicate the fundamental sources that have contributed to the Index's considerable cross-sectional variation as well as its time-series variation. Therefore, this study should be viewed as a useful historical account for those interested in understanding the ex post return-generating process of the Index and its property-type components as well as those who wish to model the ex ante return-generating process for a variety of applications in both the equity and debt markets—regardless of whether the securities are publicly or privately traded.     

Credit Restrictions and the Market for Commercial Real Estate Loans

This paper develops a model of the market for commercial real estate loans based on the variables used by investors and lenders in property decision-making: the income capitalization (cap) rate, the debt-coverage ratio and the loan-to-value ratio. Empirical results for aggregate United States real estate originations and commitments for 1970–93 indicate that loan demand is sensitive to the cap rate and to building permit issuance. The dominant criterion used by lenders is the debt-coverage ratio as opposed to the loan-to-value ratio, a finding which may have implications for underwriting standards and credit policy.     

Toward a Model of the Office Building Sector

High rise office buildings represent large capital outlays in very competitive markets. Investment and development decisions require careful market analysis to assure sufficient demand to lease the office space at rental rates which will make the venture financially attractive. Present methodology for analyzing future commercial real estate market conditions can at best be said to be inadequate. This methodology relies on concepts such as "market absorption" rates and "normal" vacancy rates. These concepts usually rely on accounting type and trend line techniques to provide forecasts of space demand. In this paper we provide an alternative methodology for forecasting the key variables in the office space market by developing a statistical model of supply and demand. The key variables that need to be forecasted are the stock of office space (in square feet), the flow of new office construction (in square feet), the vacancy rate (in percent), and the rent for office space (net rent per square foot).     

The determinants of office cap rates: The international evidence

We examine commercial office cap rates in 89 large cities in 33 developed and developing countries in the 2000–2019 period. We find that cap rates decline throughout the world over this period, reflecting a corresponding decline in the real rate of interest. In the cross-city analysis our most robust findings are that office cap rates are lower in wealthier cities, especially those that are either considered gateway cities or financial centers. In addition, cap rates tend to be higher in countries with lower credit ratings and higher inflation rates. We find that cap rates in suburban office markets are higher than in central business districts, and for a given metropolis, suburban cap rates are lower in suburbs with better public transport connections to the central business district. Finally, evidence from regressions with city fixed effects reveal that cap rates rise as the discount rate and vacancy rates increase and fall as cities get wealthier.     

Profitability of Office Rental Market in Seoul: An Application of Simultaneous Structural Equations

This article is concerned with the estimation of excess rates of return on the office rental market in Seoul using a simultaneous structural equation model. The office rental market in Seoul is spatially divided into CBD and non-CBD, and the model has three behavior equations of Chonsei price, monthly rent and key deposit, with two identity equations of conversion rate and excess rate of return. This article reveals that it would be rational for the owners to ask tenants for a higher deposit with a lower monthly rent under increasing interest rates because the interest rate has a positive effect on the Chonsei deposit and the key deposit, but a negative effect on the monthly rent. Although high nominal interest rate and low economic growth reduce the excess rate of return on both submarkets, the non-CBD office rental market would be more profitable than the CBD market despite lower levels of the monthly rent and key deposit.     

The Cyclic Behavior of the U.S. Lodging Industry

A recently constructed data series suggests that the hotel industry has experienced two rather large building booms from 1969 to 1994. By contrast, hotel demand seems to move closely with the United States economy, at a much higher cyclic frequency. Occupancy and room rental rates follow the slower movements in supply. A structural model is estimated over this series which displays long lags between occupancy and room rental rate changes, as well as between room rental rates and new supply. These lags create a system of difference equations that is close to being dynamically unstable. Forecasting forward with smooth economic growth, yields a new and even larger future building boom.     

Real Estate for the Long Term: The Effect of Return Predictability on Long-Horizon Allocations

We examine how the predictability of real estate returns affects the risk of, and optimal allocations to, real estate for investors of differing investment horizons. Returns to direct real estate are mean reverting, and risk decreases with horizon. This is driven by a tendency for property transaction prices to overshoot inflation. Mean reversion in real estate returns is weaker than that of equities, resulting in real estate having similar risk to equities for long-term investors. However, optimal portfolios have large allocations to direct real estate at all horizons, and the allocation increases with horizon. Finally, we find that real estate investment trusts are a redundant asset class for investors with access to direct real estate as an asset class, but they do have a role in optimal allocations when direct property investment is not feasible.     

Explaining Asset Mispricing Using the Resale Option and Inflation Illusion

We investigate the overconfidence theory and inflation‐illusion hypothesis of asset mispricing. Both concepts address subjective asset valuation but place the impetus on differing explanations within the standard dividend‐growth model. We find that one of the theoretical outcomes of overconfidence—asset turnover—consistently explains mispricing in U.S. housing markets. Further, we find that asset turnover subsumes expected inflation in certain specifications, suggesting that dispersion in investors' beliefs is a better explanation of asset mispricing than the investors' inability to properly discount future cash flows.     

Why are REITS Currently So Expensive?

Over the last several years, the price of listed real estate stocks has been unusually high relative to dividends. I find that neither low interest rates nor low risk premia can account for the high valuation ratios. Lower interest rates have been offset by rising risk premia to keep expected returns close to average. Instead, the market has priced in future income growth on commercial properties far above the growth rates seen in the data. High implied growth rates are less extreme for nontraditional REIT sectors. Income growth expectations are also less extreme for international listed real estate.     

Vacancy Rates and the Future of Office Rents

This research confirms the existence of a strong vacancy rental adjustment mechanism in the market for office space, such as has been found in housing markets. Using national time-series data, we find that real office rents drop approximately 2% annually, for every percentage point of "excess vacancy" in the market. We also find that the definition of "excess vacancy" has been trending upward over time. Using a recent vacancy forecast suggests that office income streams seem likely to decline in both real and nominal dollars over the next few years.     

The Liquidity of Property Shares: An International Comparison

This article investigates the magnitude and determinates of share liquidity over the 1990–2007 period in the world's four largest securitized real estate markets: the United States, the United Kingdom, Continental Europe and Australia. We document a significant and consistent role for market capitalization, nonretail share ownership and dividend yield as drivers of liquidity across markets. We also document significant differences in liquidity across countries and between property and nonproperty companies. Also striking is the lack of correlation among our three measures of liquidity across property firms and time. This supports the notion that share price liquidity is multifaceted and therefore reliance on any one measure of liquidity in empirical work may produce misleading conclusions. Although we find some evidence of a connection between liquidity and firm value, it is less conclusive than prior studies.     

The Effect of Lead Paint Abatement Laws on Rental Property Values

Lead paint is a source of childhood lead poisoning, a vicious disease with high costs to both the victims and society. Treatment of the disease requires placing the victim in a lead-free environment. Laws have been enacted by many localities, which would require removal of lead from residential property. However, property owners have resisted the enforcement of these laws with threats of abandonment. Theory suggests that abandonment will occur only if the value of the rental property after removal of the paint is less than the cost of removal. This paper shows that these costs have already been discounted into property values. Data from Baltimore, Maryland indicates that the market has placed a value of approximately $15,250 per structure or $3,813 per rental unit on expected abatement costs. This value in most cases is less than the value of the rental property. Thus abandonment should occur infrequently.     

Security Deposits, Adverse Selection and Office Leases

Our focus in this article is on the extent to which security deposits allow landlords to contract on the intensity with which tenants utilize office space. Much existing discussion recognizes that landlords expect some tenants to be more opportunistic than others, but that landlords often cannot predict a tenant's future behavior. As a consequence, landlords will charge all tenants, both low-utilization and high-utilization ones, a rental externality premium. This rental externality premium gives low-utilization tenants (or tenants with better credit quality than the market perceives) a strong incentive to sort themselves out. Our findings suggest that office rental contracts with large up-front security deposits are one way in which different tenant types can sort themselves out. Such contracts reduce landlord uncertainty and imply rental discounts in excess of the foregone interest on the deposit monies.     

An Anatomy of Price Dynamics in Illiquid Markets: Analysis and Evidence from Local Housing Markets

This research analyzes the dynamic properties of the difference equation that arises when markets exhibit serial correlation and mean reversion. We identify the correlation and reversion parameters for which prices will overshoot equilibrium ("cycles") and/or diverge permanently from equilibrium. We then estimate the serial correlation and mean reversion coefficients from a large panel data set of 62 metro areas from 1979 to 1995 conditional on a set of economic variables that proxy for information costs, supply costs and expectations. Serial correlation is higher in metro areas with higher real incomes, population growth and real construction costs. Mean reversion is greater in large metro areas and faster growing cities with lower construction costs. The average fitted values for mean reversion and serial correlation lie in the convergent oscillatory region, but specific observations fall in both the damped and oscillatory regions and in both the convergent and divergent regions. Thus, the dynamic properties of housing markets are specific to the given time and location being considered.     

Determinants of Differential Rent Changes: Mean Reversion versus the Usual Suspects

This is a hedonic regression study of the 2001–2004 and 2004–2007 rent growth of 18,000 rental units. Which variables matter: Location? Age? Rent level? Occupancy duration? Structure type? The answers deepen understanding of the rental market and help guide statistical agency practice. We document significant rent stickiness. Initial relative rent level is the best predictor, mainly because of mean reversion. (This problem likely extends well beyond the present study.) “Location” comes in second, though often not statistically significant: the relative value of location is persistent. Age and occupancy duration are also notable. Our findings support statistical agency practices.     

Implicit Forward Rents as Predictors of Future Rents

This paper investigates the relation between the term structure of rents and future spot rents. A rich database of office rental agreements for various maturities is used to estimate the term structure of rents, and from this structure implicit forward rents are extracted. The data pertain to commercial properties in the three largest Swedish cities for the period 1998–2002. A positive relation between forward and spot rents is found in some regions, but forward rents underestimate future rent levels. Another contribution of the paper lies in the area of rental index construction. We provide evidence that rental indices should not only be quality constant ( i.e. , control for characteristics), but should also be maturity constant.