Generating Cap Rate Forecasts
Generating cap rate forecasts is a multi-step and highly technical process that requires background in econometrics and experience in estimating and evaluating econometric equations. The cap rate forecasting process includes the following steps:
1. Determine the property type for which you want to forecast cap rates. Cap rate behavior and levels vary considerably across property types.
2. Determine the market for which you want to produce a cap rate forecast. Cap rate behavior varies across local markets, as it depends considerably on movements in local market conditions.
3. Obtain reliable and consistent (in terms of their measurement) cap rate data from vendors for the chosen property type and market. Note that you have to have historical data for a sufficiently long period and ideally for a full cycle over which cap rates have been rising and declining as well. The historical data may be annual or quarterly but, because cap rates move slowly, annual data may provide more robust estimates and forecasting equations.
4. Obtain also historical data for the independent variables to be used in the econometric analysis. This must include data on historical movements in critical property local market variables such as rents, vacancy rates, and absorption for the market and property type under consideration. You will also need data interest rate movements and returns in alternative investment vehicles such as stocks and bonds, as movements in local cap rates are affected by conditions in the national capital market. Historical movements in the local economy, if they can be obtained, may have some explanatory and therefore predictive power if they are available. Note that the historical data for the independent variables have to refer to the same historical period to which the cap historical cap rate data refer to.
5. Estimate alternative functional forms and econometric equations using different combinations of potential explanatory variables as well as different time lags. For example, the analyst may estimate alternative equations where the rent is lagged 0, 1, or 2 years in order to see which one is more strongly correlated with movements in cap rates. The same experimentation applies to all independent variables.
6. Select among the alternative econometric models the one that best explains historical movements in capitalization rates.
7. Obtain forecasts for the independent variables that are included in the best fitting model.
8. Produce a forecast of cap rates by using the coefficients of the best-fit model in combination with the forecasts of the independent variables in the model.
9. Examine the forecasts produced by the model for their reasonableness.
10. If the forecasts produced strike as unreasonable and extreme use second best-fitting model to produce forecasts, and repeat steps 9 and 10 until you get a forecast that seems reasonable, given the historical behavior of cap rates in that market and property type.