Land Economy Tripos - Paper 15: Lecture 1

Real Estate as Investment

Daniel Ruf, Ph.D (dr609@[Link])

Land Economy, University of Cambridge

October 9, 2025
Content

Paper 15
Advanced Techniques in Finance and Investment
for Real Estate

1.1 What to expect from Paper 15?

1.2 Understanding Cap Rates (Yield)
1.3 Real Estate as Investment
1.1 What to expect from Paper 15?

Aim: We apply core finance and investment market theory to

commercial and residential real estate markets.

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1.1 What to expect from Paper 15?

Real Estate Finance with Land Economy Twist

▶ strengthen understanding of real estate markets

⇒ real estate as an investment and commercial real estate
⇒ how to finance real estate investment?

▶ understand real estate as part of financial market

⇒ real estate debt and equity in private vs public market
⇒ measure performance in investment portfolio

▶ emphasis on understanding principles

⇒ also deepen quantitative analytic skills
⇒ build on concepts from past Papers 3, 4, and 6

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1.1 What to expect from Paper 15?

Brief Outlook: Investment Perspective

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1.1 What to expect from Paper 15?

Brief Outlook: Financing Perspective

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1.1 What to expect from Paper 15?

Topics in Michaelmas

Lecturer: Daniel Ruf

01. Real Estate as an Investment Oct 9
02. Public versus Private Real Estate Markets Oct 16
03. Private Real Estate Pricing: Valuation Principles Oct 23
04. Measuring Real Estate Performance Oct 30
05. Data Limitations and Index Construction Nov 6
06. Real Estate in the Mixed Asset Portfolio Nov 13
07. Real Estate Factor Risk Nov 20
08. Real Options and Land Value Nov 27

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1.1 What to expect from Paper 15?

Topics in Lent

Lecturer: Dongxiao Niu

01 Real Estate Debt
02. Debt and Mortgage Calculations
03. Mortgages and Household Financial Decision Making
04. Securitization and Global Financial Crisis
05. Real Estate and the Macroeconomy
06. Risk and Uncertainty in Real Estate Markets
07. Environmental Issues and Real Estate Markets
08. Indirect Real Estate Investments

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1.1 What to expect from Paper 15?

Building Blocks

▶ Lectures apply techniques and principles to real estate finance

and investments
⇒ supporting material (refreshers) will be provided

▶ Supervisions help to train and deepen the understanding

⇒ data-driven approach (with Excel)

▶ Paper 15 offers integrated R sessions

⇒ knowing a bit of R might be a valuable skill

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1.1 What to expect from Paper 15?

Getting started in R: great open-source material that can be

used (maybe helpful for your dissertation?)

▶ working with tidy data in R: R for Data Science

▶ empirical methods in R: Introduction to Econometrics with R

▶ Introduction to Computational Finance and Financial

Econometrics with R: introcompfinR

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1.1 What to expect from Paper 15?

Literature - Don’t read everything in detail!

▶ Geltner, D., N.G. Miller, J. Clayton, and P. Eichholtz (2007),

Commercial Real Estate Analysis and Investments, 2nd ed.,
Mason OH: South-Western Publishing/Thomson Learning.

▶ Brueggeman, W.B. and J.D. Fisher (2011), Real Estate

Finance and Investments, 14th ed., New York: McGraw-Hill.

▶ Selected academic articles will be uploaded on Moodle.

⇒ What are key messages of paper?

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1.1 What to expect from Paper 15?

Feedback
▶ If you want true feedback, prepare supervision exercises!
▶ data-driven approach: You will get your hands dirty!
▶ direct interaction during supervisions/lectures

Dissertation Topics
▶ Let’s talk - I supervise undergraduate dissertations
▶ Interested in real estate topics? Land Economy Databases!

Current trends in real estate industry?

▶ Professional Real Estate Practice Seminars, organised by Nick
Mansley (usually Thursdays, 5:00-7:00pm)
⇒ Targeted at MPhil in REF, but Paper 15 students are
welcome!

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1.2 Understanding Cap Rates (Yield)

From Cash Flows to Values

▶ Discounted Cash flows: value is sum of future cash flows,

discounted back to today
∞
X CFt
V0 =
t=1
(1 + rt )t

▶ if we assume that CFs are an increasing perpetuity, and g is

the long-run average growth rate and r is the required return
for equity holders, then
CF1
V0 =
(r − g)

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1.2 Understanding Cap Rates (Yield)
DiPasquale and Wheaton (1992) 4Q Model

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1.2 Understanding Cap Rates (Yield)

Yield (cap rate) is observable, but not constant in time

(e.g. Amsterdam gross yields)
CF1 CF1 CF1
V = = ⇒ cap =
cap r −g V

▶ decompose yield into required return and growth and model

individually

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1.2 Understanding Cap Rates (Yield)

Decompose total required return

▶ (required) total return for investment

CFt + Vt − Vt−1 CFt Vt − Vt−1

rt = = +
Vt−1 Vt−1 Vt−1

with
CFt = net cash flow paid out to investor in period t
Vt = market value of the asset at end of period t

can be decomposed in two components:

- capital gain (appreciation return): gt = (Vt − Vt−1 )/Vt−1
- cap rate (current yield): capt = VCF t
t−1

hence: rt = capt + gt ⇒ capt = rt − gt

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1.2 Understanding Cap Rates (Yield)
Asset Market - Price Determination

▶ asset valuation risk: changing opportunity costs of capital in

asset market ⇒ expected return required by investors
Rent
cap = =r −g
Price

▶ cash flow risk: expected rent growth (space market)

Rent
cap = =r −g
Price

▶ How is it linked to discounted cash flow model?

E0 [CF1 ] E0 [CF2 ] E0 [CFT −1 ] E0 [CFT ]

V = + 2
+... T −1
+
1 + E0 [r ] (1 + E0 [r ]) (1 + E0 [r ]) (1 + E0 [r ])T

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1.2 Understanding Cap Rates (Yield)

Normative View on Discount Rate

▶ What might be the correct discount rate r ?

▶ Discount rate reflects

- time value of money: reward for giving up capital
⇒ risk-free rate rf
- compensation for risk: r = rf + RP

▶ Real assets: depreciation

- account for depreciation in cash flow or in r ? Both possible?

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1.2 Understanding Cap Rates (Yield)
Risk-free rate

▶ yields on 10-year US Treasury bonds, nominal and real

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1.2 Understanding Cap Rates (Yield)

Capital Asset Pricing Model (CAPM)

E [ri ] = rf + RPi = rf + βiM (E [rM ] − rf )

COViM
with regression slope coefficient βi = VAR(r M)
as quantity of
risk and E [rM ] − rf as market price of risk

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1.2 Understanding Cap Rates (Yield)

How high have historical growth rates really been?

▶ commercial real estate returns (nominal), City of London

⇒ r = cap + g = RP + g

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1.2 Understanding Cap Rates (Yield)
How high have historical growth rates really been?

▶ commercial real estate returns (real), City of London

▶ negative capital gains: in real terms, all growth came from
income

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1.2 Understanding Cap Rates (Yield)

What might be the correct discount rate?

▶ Decomposing yield to back out required return (r )

▶ if we have realistic estimates for some parameters, can we back
out the market consensus for anything missing?
cap = r − g required return r , growth g
(yield is directly observable, r and g not)
r = rf + RP risk free rate + risk premium
rf = rf ,real + E (f ) real risk free rate, expected inflation E (f )
Fisher model of interest rates
g = greal + E (f ) real growth, expected inflation
cap = rf ,real + E (f ) + RP − greal − E (f )
cap = rf ,real + RP − greal inflation cancels out

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1.3 Real Estate as an Investment
Comparative performance: Evidence from 1870 to 2015

▶ return comparison for major asset classes in 16 advanced

economies: housing, stocks, safe assets
Q 1/T
T
▶ geometric mean t=1 (1 + Rt ) −1
- annualized return that would be achieved through
reinvestment (compound return)

Source: Jorda et al. (2019)

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1.3 Real Estate as an Investment

Housing vs Equity: Return decomposition

▶ total return Rt = Pt −Pt−1 CFt

Pt−1 + Pt−1 = g + cap

Source: Jorda et al. (2019)

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1.3 Real Estate as an Investment
Housing vs Equity: Long-term performance

Source: Jorda et al. (2019)

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1.3 Real Estate as an Investment

Housing vs Equity

▶ excess returns ERt = Rt − rtbill

Source: Jorda et al. (2019)

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1.3 Real Estate as an Investment
Housing vs Equity: Sharpe Ratios

▶ Sharpe ratio: ER t /σt

⇒ higher excess return on housing (per unit of risk)

Source: Jorda et al. (2019)

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1.3 Real Estate as an Investment
Better data: Total Return and Risk to Real Estate

▶ Eichholtz et al. (2021): exploit asset-level total returns: based

on collected rents, costs, taxes, prices for real estate in Paris
(1809-1943) and Amsterdam (1900-1979)
▶ in Jorda et al. (2019), total returns as combination of
aggregated rent, price, and cost indices, problematic if
properties from different samples and locations are not fully
comparable

Source: Eichholtz et al. (2021)

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1.3 Real Estate as an Investment

Better data: Normal Sharpe Ratios

▶ Eichholtz et al. (2021): Sharpe ratios are significantly lower

when measuring returns at asset level

Source: Eichholtz et al. (2021)

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1.3 Real Estate as an Investment

Summary

▶ Jorda et al. (2019): housing outperformed equities in the long

run with similar returns but significantly lower volatility
- contradiction with theory (asset pricing puzzle?) or due to
mismeasurement?
- other studies, e.g., Eichholtz et al. (2021), find lower Sharpe
ratios for housing

▶ Potential reasons
- maintenance costs: lower rental yield (gross vs net yield?)
- taxes: not accounted for taxes, when computing equity and
housing returns (both assets are taxed differently)
- transaction costs: house seller incurs transaction costs
- geographic coverage: price and rent data collected from
different locations
- leverage: debt-financing of housing is neglected (LENT)

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