Students Should Be Able to:
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
Hong Kong Real Estate
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
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
Rental Yields & Cost of Capital
Payoff to owning Capital cost of real
property is rent, R. estate includes
Define rental yield, Interest rate, i
y, as the ratio of Depreciation/Maint
rent to property enance Costs δ
prices, PPE. Property Taxes: τ
Other Costs: c RE
PMPK RE R P
Capital Gains, g
(i c tw g PRE
Cost of Capital Theory & Real Estate
Constructing New Buildings has long
lead times. For a fixed stock of
buildings we can use cost of capital
theory (y = ckRE) to derive prices as
a function of rents.
R ck P RE R
(i c tw g P RE
(i c tw Pt RE
R↑ → ↑
i↑ ← ↓
δ↑ ← ↓
tw ↑ ← ↓
c↑ ← ↓
↑ → ↑
Real Estate Pricing
(i c tw Pt RE
A key determinant of the price of
real estate is the expected capital
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 Prices
HK: Pro perty Capital Value: Residential: Medium
Dec-1988 Dec-1990 Dec-1992 Dec-1994 Dec-1996 Dec-1998 Dec-2000 Dec-2002
Credit Cycles: Real Estate
Much of corporate collateral is real
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
The Financial Accelerator
Adverse Economic Shock
Fire sales of commercial
Declining corporate net
property to pay back bank worth
loans leading to further
declines in prices
Lower investment and
reduced demand for real
Falling collateral values
and worsening bank
balance sheets lead to
declining bank loans
Falling Real Estate Prices