Forecasting cap rates has long been a focus of the real estate industry. They are seen as determinants of value in the sector, and their relationships to interest rates, although volatile, have been assumed to be the best forecast available. But after meeting at a conference, FCP’s Matt Larriva, CFA and Dr. Peter Linneman traded ideas over what a better forecast of cap rates would look like. Dr. Linneman had, years earlier, written a piece describing how funds flows were a far more accurate indicator of cap rate directions than interest rates were. Matt Larriva took the idea and applied a sophisticated statistical model to it, resulting in a mathematically robust forecast method that showed strong performance at forecasting cap rates. Furthermore, the new method did so completely without reference to interest rates, which had previously been assumed to be integral to cap rates. Per Larriva, “We’re in a period where interest rates are pushing a practical lower bound, and the former assumption that cap rates follow interest rates will become nearly useless at these levels. To the extent it was ever right in the first place, it’s hard to forecast a dependent variable when the independent variable can’t move. The new method references just former cap rates, unemployment rates, and funds flows—the amount of capital chasing real estate as a percentage of GDP.” Larriva’s work with Dr. Linneman was considered novel and edifying and was published in the peer-reviewed Journal of Property Investment and Finance.
