Estimating Net Operating Income Growth for Modeling U.S. Apartment Property Capitalization Rates

The properties of income-to-price ratios in asset markets have potentially far reaching implications for understanding investor behavior. Prevailing levels of commercial real estate (CRE) capitalization rates, similar to price/earnings ratios for stocks and owner equivalent rent-to-price relatives for houses, may foretell future investment returns and income growth rates. In CRE capitalization rate models, rent growth rates often proxy for the net operating income (NOI) growth rates. Empirical studies of capitalization rate predictive powers produce inconsistent results that may be due either to the use of these rent growth proxies, model misspecification, or both. We use a novel approach for generating NOI growth rate estimates that involves combining survey rent and the expense growth rates for U.S. apartments. Our GARCH analysis of the capitalization rate spread process using the estimated NOI growth rate produces theoretically consistent results. Importantly, we demonstrate efficiency gains from using our NOI growth rate estimates relative to traditional rent growth rate.