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Determining Real Estate Betas for Markets and Property Types to Set Better Investment Hurdle Rates
Executive Summary. Corporate theory states that investment decisions are best made with a hurdle rate that is adjusted for each investment’s risks. Although determining a real estate risk premium has been employed by many investors, calculating differential risk premiums within real estate are rareand usually proprietary. Many real estate investors, in fact, may not be aware of the actual risk associated with different property types or markets. Some investors have attempted to apply the Capital Asset Pricing Model (CAPM) for a private real estate investment using real estate investment trust (REIT) returns to develop betas for private investments. This paper compares property and marketbetas for both private real estate (using the NCREIF Index) and public real estate (using the NAREIT Index) so that investors can have a more accurate risk premium beta or benchmark for their decisions.

by Manuel Breidenbach* Glenn R. Mueller** Karl-Werner Schulte***

Introduction
Many investors set only one investment hurdle rate for their private real estate investments and run the risk ofoverpaying for an asset that is exposed to higher levels of risk. Few adequate methods for calculating the risk-adjusted return on equity (required for a direct investment in a risky real estate asset) exist. This is caused by the common practice of purchasing real estate assets based on current ‘‘market determined’’ capitalization rates. These cap rates are driven by ‘‘what people are currentlypaying for real estate assets’’ and is partly a function of how much capital is chasing the real estate assets (Mueller, 1995). The investment decision, however, should be independent of how much capital is chasing a particular asset. It may be better to sit on the sidelines for a year or two as opposed to buying a property at such a high price. Investors should have a required rate of return thatis not driven by the perceived market rate. Part of the problem with applying a capital market valuation technique to a private inefficient market is the lack of available data. Another problem is that proxies such as publicly traded assets (real estate investment trusts, or REITs) may not be comparable to private market investments. Thus the key problem in applying the Capital Asset Pricing Model(CAPM) to private real estate is the calculation of a meaningful beta. As a result, there is a need for a model that will allow private real estate
Journal of Real Estate Portfolio Management 73

*European Business School, Oestrich-Winkel, D65375 Germany or breidenbach@ebs-immobilienakademie.de. **Colorado State University, Fort Collins, CO 80523 or Glenn.Mueller@colostate.edu. ***EuropeanBusiness School, Oestrich-Winkel, D65375 Germany or schulte.ebs@t-online.de.

Manuel Breidenbach, Glenn R. Mueller, Karl-Werner Schulte

investors to accurately assess the risks that affect the cost of equity and use that model as a valuation alternative to the popular current investor surveys that may be misleading. This study estimates a market risk premium for direct private real estate, andthen develops a beta analysis by property type so that investors can differentiate risk premiums for each property type. It compares NCREIF property betas to NAREIT property betas and finds some similarities and some differences. It then develops a metro market beta for the office property type using a long-term data set that encompasses one full market cycle. This is important for investors becauseusing NCREIF data, in order to arrive at beta values, allows the investor to calculate investment hurdle rates based on their relative risk. It may also allow for a comparison with current and historic cap rates and hence provides an alternative valuation tool to investor surveys. The goal of this project is to use the CAPM, which is primarily used in the public capital markets for determining...
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