Housing return and the determinants of the capitalization rate: With reference to Hong Kong

Summary Property yield constitutes only part of the rate of return on real estate. The financial leverage effect of mortgage loans coupled with house price appreciation contributes significantly to real estate return. In equilibrium, the movement of property yield will be determined by the real rate of interest, and house prices should grow in line with rents. Based on the equilibrium condition, the multi‐period real estate return can be constructed. The higher the expected return, the more attractive real estate investment becomes. When an average value of the inflation rate is taken as a proxy for expected inflation, the mean risk premium of real state in Hong Kong is found to be 8% more than the prime rate. The higher future capital appreciation is expected to be, the lower the risk premium which will be required, which in turn will lead to a lower property yield. Our empirical evidence estimates that a one percentage point increase in the real interest rate will bring about an increase of 0.5 percentage points in the property yield. The drastic increase in Hong Kong house prices in 1991 was mainly due to expected rising inflation, fuelled by a decreasing interest rate.