Investment Characteristics

1. Cash flows come in the form of rent, which can be viewed as being analogous to the coupon income derived from a bond.

2. The equity component. When the lease on a property expires, the investors have options of re-renting it, selling it, or redeveloping it for a future sale. This decision depends on the value of the property at the time. The potential for profit or loss adds an equity-like dimension to commercial real estate investment.

3. Illiquidity. It can take months or even years to sell a commercial property, and the transaction costs are usually very high.

The Pricing Formula

The basic pricing formula can be applied to commercial real estate in a similar way.

The expected cash flows, both rental income and future property value, are uncertain.

We need to add two components to the discount rate:

• Κⁱ_t,s: The commercial real estate risk premium is analogous to the equity risk premium.
• Φⁱ_t,s: The illiquid nature of property investment means that investors may also demand a liquidity premium for investing in this asset class. This is the key difference between the discount rates applied to the cash flows of equities and commercial real estate properties.

Like equities, commercial property is not a very good hedge against bad economic outcomes. Even though nominal rental income is relatively stable, the capital values of commercial property are highly sensitive to the business cycle. Investors will generally demand a relatively high risk premium in return for investing in this asset class because of the pro-cyclical nature of commercial property prices. The risk premium tends to be positively correlated with the risk premiums on corporate bonds and equities.