Chapter 23

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
Calculate the real and nominal cost of capital for real estate.
Analyze the effects of changes of different elements of cost of capital on rental yields and real estate prices.

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


According to the planning department rental yields on residential apartments are more than 5%.
Rental yields are the annual rent divided by the price level.
But interest rates on mortgage loans are
2.5%.
Why don’t people want to borrow at 2.5% to make 5.1% returns?

Property the ultimate non-traded asset!


Real Estate is an important type of physical capital investment and a special type of financial investment.


Uniqueness- Each location of property is unique, making it harder to value.
Illiquid – Harder to sell than paper financial assets, longer lead times for building real property.

Large share of the wealth of middle income households.

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
Payoff to owning property is rent, R.
Define rental yield, y, as the ratio of rent to property prices, P PE .
PMPK
RE 
R y

R
P
RE ck
RE

Capital cost of real estate includes





Interest rate, i
Depreciation/Maint enance Costs δ
Property Taxes: τ
Other Costs: c
Capital Gains, g
P
RE
 c tw g
P
RE
) P
RE


Constructing New Buildings has long lead times. For a fixed stock of buildings we can use cost of capital theory (y = ck RE ) to derive prices as a function of rents.
R
 ck

P
RE 
1
R
( i

P
RE
)
1

( i

 
P t
1 )
R

Curve P RE
R ↑ i ↑
δ ↑
→
←
← tw ↑ ← c ↑ ←
↑
↓
↓
↓
↓
P t
RE

1
↑ → ↑

45%
P*
( i

1 c tw

 
)
P t
R
P RE




A key determinant of the price of real estate is the expected capital gain.
Expected deflation explains why rental yields are so much higher in
HK than mortgage rates.
Waves of optimism and pessimism may lead to persistent fluctuations in property prices.

HK: Property Capital Value: Residential: Medium
HKD/Sq ft
5500
5000
4500
4000
7000
6500
6000
3500
3000
2500
2000
1500
Dec-1988 Dec-1990 Dec-1992 Dec-1994 Dec-1996 Dec-1998 Dec-2000 Dec-2002

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

Much of corporate collateral is real estate.
Real estate is good collateral because it cannot be easily moved and its value is relatively easy for outsiders to derive.
Fluctuations in property price have effects on cost of capital and investment.

The Financial Accelerator
Adverse Economic Shock
Fire sales of commercial property to pay back bank loans leading to further declines in prices
Declining corporate net worth
Falling collateral values and worsening bank balance sheets lead to declining bank loans
Lower investment and reduced demand for real estate
Falling Real Estate Prices