The Secular and Cyclic Determinants of Capitalization Rates: The Role of Property Fundamentals, Macroeconomic Factors, and "Structural Changes"

In this article, the authors revisit many studies that have attempted to explain the determinants of real estate capitalization rates. Two new innovations are introduced. First, the authors identify two macroeconomic factors, in addition to risk-free Treasury rates, that greatly impact cap rates-the general corporate risk premium operating in the economy and the amount of debt (liquidity) available. The addition of these factors greatly adds to the ability of previous models to explain the secular fall of cap rates in the last decade and their recent rise. Second, the authors search for "structural" shifts in the cap rate using innovative tests, including a large number of macroeconomic factors. The tests identify two distinct periods that the authors label as "investor sentiment." A period of negative sentiment was identified from 1991 to 1996 and a period of positive sentiment was identified from 2002 to 2007. Methodologically, the analysis uses a large and robust quarterly panel dataset of 30 U.S. metropolitan areas from 1980 Q1 through 2007 Q4. The authors compare the models using traditional measures of within-sample fit, as well as how the models behave in in-sample backtest forecasts.