Capitalization Rates, Discount Rates, and Net Operating Income: The Case of Downtown Chicago Office Buildings

Abstract

Executive Summary.The value of commercial real estate is its net operating income divided by the capitalization rate set by the buyer. This study examines both components of value. It also examines the close relationship between capitalization rates and risk-adjusted discount rates used in commercial real estate investment. The paper includes an empirical study of the capitalization rates for 132 office building sales in downtown Chicago from 1996 to 2007. The capitalization rate is hypothesized to be a function of the classic capital asset pricing model variables and variables intended to capture the expectation that the real market value of the building will change. The empirical results are then used to provide estimates of the real risk-adjusted discount rates that were used by the investors in these properties. The paper also includes estimates of a model of net operating income for these buildings.