One common approach for finding total expected returns is to use market extraction, which involves looking at cap rates of recently sold, comparable properties and then using those cap rates as a guide in evaluating the subject property. Once the investor determines the appropriate cap rate, it is possible to estimate the total return by adding the cash flow growth rate to the cap rate.
Another approach for estimating total returns is use historical risk premiums, which produce a total return expectation by adding risk premiums to the risk-free rate of return.
In theory, the two approaches should produce similar total returns. If not, it is an indication that properties are being mispriced in the marketplace compared to historical pricing levels. The risk premium method is helpful for spotting inflated asset prices, since it leads to valuations based upon historical returns. If investors rely exclusively on the market-extraction method, they run the risk of participating in and contributing to price bubbles in real estate.
A buyer of real estate may be more interested in what a cap rate should be, while a seller tends to be particularly interested in how market participants are pricing assets at a particular moment in time. It is up to the investor to reconcile the return estimates from the various approaches. The exercise of valuing properties using several approaches can help to determine whether it is a good time to buy or sell real estate.
In some cases, it is difficult to extract cap rates from the market, because there are few sales comparables. This is particularly true in many smaller apartment markets where the risk premium approach is a better option than market extraction.
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