Equity Reit Returns for Deriving a Discount Rate for Unsecuritized Commercial Real Estate

Problems with appraisal-based return series combined with certain similarities between commercial real estate, bonds and stock suggest that equity REIT returns provide an accurate source of real estate pricing information. A model for deriving a discount rate for unsecuritized commercial real estate was developed. The model is a three factor Arbitrage Pricing model that measures the sensitivity of equity REIT returns to a small stock portfolio, a bond portfolio and a real estate portfolio. To circumvent limitations of appraisal-based return series for commercial real estate, a synthetic index was created which capitalized the FRC-NCREIF index by an equally weighted average of quarterly capitalization rates published by the American Council of Life Insurance. The synthetic FRC/ACLI total return index had similar volatility and dispersion as the NAREIT equity total return index but exhibited lower mean quarterly returns. The correlation between the NAREIT equity index and the FRC/ACLI index was.2662. In tests of the three factor model using both the FRC-NCREIF index and the synthetic FRC/ACLI index the real estate factor was not statisitically significant. Accordingly, that factor was dropped from the pricing model. A case study was conducted using the modified pricing model for deriving an appropriate cost of capital in the first quarter of 1990, for a hypothetical neighborhood shopping center located in a mid-Atlantic state. The pricing model produced an unlevered discount rate of approximately 14% Thesis Supervisor: Marc A. Louargand Title: Lecturer, Department of Urban Studies and Planning