This article examines the relation of the substitution principle and overall capitalization rates. Although investors may substitute between low- and high-quality investment-grade property of the same type and within the same market, differences in property quality can cause large variations in overall capitalization rates. This study finds overall capitalization rates for apartments, office, industrial, and retail property to be cointegrated, suggesting that the principle of substitution applies across property types. Variation in rates by property type is attributed to the equity capitalization rate and the loan-to-value ratio rather than to the mortgage capitalization rate. The overall capitalization rate for real estate Is not cointegrated with capital market yields, Indicating that real estate is not a good substitute for stocks and bonds.
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