Expected Returns and Expected Growth in Rents of Commercial Real Estate

Commercial real estate expected returns and expected rent growth rates are time-varying. Relying on transactions data from a cross-section of U.S. metropolitan areas, we find that up to 30% of the variability of realized returns to commercial real estate can be accounted for by expected return variability, while expected rent growth rate variability explains up to 45% of the variability of realized rent growth rates. The cap rate--that is, the rent-price ratio in commercial real estate--captures fluctuations in expected returns for apartments and retail properties, as well as industrial properties. For offices, by contrast, cap rates do not forecast (in-sample) returns even though expected returns on offices are also time-varying. As implied by the present value relation, cap rates marginally forecast office rent growth but not rent growth of apartments, retail properties, and industrial properties. We link these differences in in-sample predictability to differences in the stochastic properties of the underlying commercial real estate data-generating processes. Also, rent growth predictability is observed mostly in locations characterized by higher population density and stringent land-use restrictions. The opposite is true for return predictability. The dynamic portfolio implications of time-varying commercial real estate returns are also explored in the context of a portfolio manager investing in the aggregate stock market and Treasury bills, as well as commercial real estate. The Author 2010. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org., Oxford University Press.