N°25-31: Navigating Information Imperfections in Commercial Real Estate Pricing

Purpose-This paper provides a critical review of the methods that can be used to estimate the discount rate or the capitalization rate needed to apply an income approach to value. It is based on the author's keynote address at the ESPI International Real Estate Conference in Paris in November 2024. Design/methodology/approach-We start by discussing the usefulness of asset pricing models from financial economics to derive discount rates. We then turn to a discussion of the build-up method which explicitly takes into account property-specific factors when assessing the riskiness of real estate investments and hence property values. Next, we discuss some key findings from papers that have relied on multi-factor models to uncover the determinants of discount and capitalization rates. We highlight the progress that has been made in gaining access to data and in modelling discount and capitalization rates. Findings-Although useful from a conceptual point of view, the main asset pricing model, the Capital Asset Pricing Model (CAPM), has limited use for real estate given its underlying assumptions. The build-up approach is intuitively appealing and is often used in practice, although it leaves much leeway to appraisers. Multi-factor models are useful and are increasingly being used with transaction-based data rather than appraisal-based data. Machine learning should further our understanding of the determinants of discount and capitalization rates. Originality/value-This paper provides a critical review of the methods that can be used to assess discount and capitalization rates. It also highlights some of the changes which have occurred recently and are likely to continue in the future. We maintain that studies analyzing the determinants of discount and capitalization rates are especially useful when conducted using micro-level transaction data.