Investor Rationality: Evidence from U.K. Property Capitalization Rates

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Abstract

Recent analyses have suggested the irrationality of Australian and U.S. office property investors in that they have failed to raise capitalization rates sufficiently at rental cyclical peaks to account for the obvious mean reversion in real rents and thus have significantly overvalued properties. In this article, we present a model of capitalization rates and explain U.K. office and retail cap rates in an error correction framework. We demonstrate that our proxies for expected real rental growth do, in fact, forecast future real growth and that cap rates reflect rational expectations of mean reversion in future real cash flows. Moreover, property cap rates are linked to the equity capitalization rate (dividend/price ratio) and expected real dividend growth in the expected manner.

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