The real estate risk premium : A developed/emerging country panel data analysis

The objective of this paper is to identify the determinants of office capitalization rates for a panel of 52 countries (developed and emerging countries) between 2000 and 2006. Our assumption, based on Capital Asset Pricing Model, is that the capitalization rate should be at least proportional to the country’s risk perception, as measured by the risk premium on the 10-year government bond yield. Because of the endogeneity of the latter variable, our empirical methodology requires that we estimate first a model explaining the 10-year bond yield. It will be the occasion to discuss the determinants of the risk premium on the bond market. Using a SURE random effect Hausman-Taylor estimator (Hausman & Taylor, 1981), w also take into account the possible correlation between the country risk characteristics on the bond markets and those that determine the real estate market. Our results show that government bond yield is the main determinant of the capitalization rate. We estimate that 1 percentage point increase in the government bond yield will raisse the capitalization rate by about 0.19 percentage point. Real estate variables play also a role, but to a lesser extent. Turning to determinants of the 10-year bond yield, macroeconomic fundamentals are significant determinants of the country risk premium, especially the capacity to honor short-term financial engagements. In addition, the country’s risk history has also very important effect on the investors’ current risk perception.