In this post, I aim to demonstrate how sensitive the long-term value of real estate can be to short-term shocks.

By “shocks,” I mean unplanned changes in both the supply and demand of real estate and the interest rates in the capital market.

Unplanned Changes in the Real Estate Market

Let’s assume we have a property generating an annual net income of $100,000. We expect this income to grow by 3% annually, and based on the capital market, the required discount rate is 12% (meaning the market expects a 12% annual return for a similar investment). Accordingly, the value of such real estate is $1,111,111, and the Cap Rate is 9%.

Now, suppose there is an unexpected increase in demand in the real estate market, causing the projected rent growth for the next two years to rise from 3% to 5%. In the long run, supply adjusts, and the anticipated long-term growth reverts to 3%. How will this affect the value of the real estate and the current Cap Rate?

As shown in the table, a 2% unplanned increase in rent growth over the short term results in a 4% increase in the value of the property.

Now, let’s assume there is an unplanned oversupply in the market, leading to an expectation that rents will remain flat for the next two years, while the long-term growth remains at 3% (driven by expected inflation). How will this affect the value of the property and the Cap Rate?

As shown in the table, a 3% reduction in expected rent growth for two years decreases the property’s value by 5%.

This highlights the type of sensitivity we are dealing with.

Unplanned Changes in the Capital Market

A similar analysis can be applied to shocks in the capital market, specifically changes in general interest rates that affect the discount rate. For example, if the risk-free interest rate rises, it will increase investors’ required returns in real estate, and vice versa.

The table shows how changes in the discount rate impact property values in our example. For instance, if the discount rate decreases from 12% to 10%, the property value increases by 28.6%.

Here is what the graph looks like:

Combined Effects of Market and Capital Factors

The following table presents the results of the parallel impact of both product and capital market factors:

You can view the Excel file here: Excel File

Adapted from:
Real Estate Finance & Investments by William B. Brueggeman and Jeffrey D. Fisher