When assessing a commercial property, it’s essential to consider all of the risks, values and cash flows that can come from taking up a new investment. The Capital Asset Pricing Model can help determine the relationship between your potential asset’s risks and expected return. This model can protect your business from dangerous investment decisions.
What is the Capital Asset Pricing Model?
The Capital Asset Pricing Model is a formula that investors use to assess risk versus expected return. By calculating the relationship between a commercial property’s expected risk-free rate and market risk premium, investors can understand how valuable a property is through its expected return of investment. The CAPM formula is as follows, where βi is the beta of investment:
Risk-free rate + βi (market risk premium) = Expected return of investment
Investors take on new assets assuming that they will be compensated for their time and money. This calculation accounts for the time value of money through the risk-free rate. By contrast,the beta of investment measures how much the investment would add to the investor’s portfolio in the current market. The market risk premium is the return expected from the market above the risk-free rate, which can tell the investor whether or not the asset is viable with their required rate of return.
Capital Asset Pricing Model in Commercial Real Estate
CAPM is used most often in commercial real estate to assess risk measures by property type. For this, investors need to put the CAPM within the context of the entire market’s historical returns as well as those for the specific property type. It’s these historical returns that tell investors what to expect for future returns.
The specific property types are apartments, offices, retail, industrial and hotel properties. The historical returns of these property types are calculated by the National Council of Real Estate Investment Fiduciaries and, when applied to CAPM, be run in a regression to calculate systematic risk for that property and, in turn, the investor’s potential purchase.
Investors in the stock market and real estate market alike use the CAPM formula to evaluate whether a potential asset is not only fairly valued, but worth the time and money for its expected rate of return. By calculating the value of the property and its potential to earn more money in the long-term, commercial real estate investors can make more informed decisions for their property investment portfolios.