capital asset pricing model (capm)

CAPM is used in relation to social discount rates. However, the method can be used to determine the capitalization rate to value 
an investment property. The concept was developed by William Sharpe (Sharpe, 1964). The method assumes that the total risk of
an investment property (this is the same as the equated yield rate or return) is not a major influence on market value but rather,
the marginal risk particularly that margin over and above a "safe" investment is the most important factor.

The method is a good measure of relevant risk determined from opportunity cost investments. It recognises the market assessment
of an investment property as one of a number of investment alternatives competing for the investor's money.
The assumptions of the model mirror those for market value:
The above assumptions result in a model which is a competitive and an equilibrium market similar to the concept of investors' utility 
- Ratcliffe, 1970. The portion of risk which can be eliminated through diversification and therefore, unrelated to the market is called
risk or diversifiable risk. The sum of the 2 risk components is the total risk (or equated yield).
The risk factors are expressed as BETAs:



BETA_TR = total risk or equated yield
BETA_S = systematic or market related risk
BETA_D = diversified or unsystematic risk

Systematic risk (BETA_S) assumes that the market value of an investment property is correlated to or dependent on movements in
the general level of all investment prices. The level of all investment prices is influenced by general economic conditions which are best
measured by the State Domestic Product (SDP) or if available Regional Domestic Product. Systematic risk measures the relationship
between movement in the price of an individual asset and the market and under the CAPM model the relationship is linear.
Under the concept Investment return can be found with the following equation:

R = RR + BETA(MR-RR) + a

The above formula states that the investment return is a linear function of the market return (MR) and the sum of the riskfree rate (RR)
and a risk premium.

a= unsystematic risk which is about 0 if the investor is rational and diversifies.
BETA = slope of the line and is the relative risk measure.

As BETA increases so does risk and the investment return. Only by assuming greater risk can the investor increase their return.
The value for the risk free rate can be determined from government bonds or monopoly utilities.

Once the BETAS have been determined the CAPM formula quickly provides the equilibrium minimum required return for any
investment given its relative risk measure (BETA value). BETAS can be analysed from sales of investment properties.


From sales analysis the market return (MR) for comparable properties is 12% and from state government bonds,
the riskfree rate (RR) is 9%.
Using the formula the following table can be constructed:








As the risk (BETA) increases, the required rate of return increases by a risk premium amount =
BETA * market risk premium, this line is called the capital market line. The resulting rate can then be used as the equated yield
to determine the market value of the subject property.