Capital Asset Pricing Model
Introduction
The capital asset pricing model (CAPM) is used widely in finance and investments. In this text I look at what CAPM is as well as how one can use financial theory risk to predict capital asset pricing of real estate prices model.
Capital asset pricing model
Capital asset pricing model (CAPM) is used to come up with an appropriate required rate of return of a particular asset. It is used in individual assets pricing as well as portfolio pricing. Wang (2001) advances that CAPM can help an investor to determine whether a real estate investment is a good investment first by calculating the required rate of return [E(Ri)]. A comparison is then made between the calculated required rate of return and the expected rate of return of the real estate asset over a given time period.With regard to risk, CAPM represents portfolio risk be less predictability, that is, a higher variance. This could be taken to mean that the exposure a real estate investor takes should be defined by the beta of his portfolio because according to CAPM, it is possible to maximize the risk-return portfolio. Adding a real estate asset into a portfolio enables the investor to diversify the portfolio further and hence the portfolio that is maximized should contain every asset.
Conclusion
Using CAPM, under priced real estate assets have a higher estimate price than the CAPM valuation while overpriced real estate assets have a lower estimated price than the CAPM valuation. Investors should hence use CAPM to determine undervalued as well as overvalued assets. However, real estate investors should be aware of the various assumptions as well as shortcomings of CAPM.
References
Wang, P. (2001). Econometric analysis of the real estate market and investment. Routledge
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