Cyclical Capitalization

An article in the Wall Street Journal referring to Lehman Brothers explained that “When it failed the estates of the collapsed investment bank listed its real estate holding as valued at 23 billion of dollars ... e 23 billion of dollars has been written down substantially. In all, Lehman expects to receive some of 13.2 billion dollars between 2011 and 2014 . . . .” (Brown, 2011) It would be interesting to understand how the large real-estate position of one of the most important investment banks has been valued. At the moment, we know that Lehman Brothers was one of the most important players in commercial property before it collapsed. We know also that Lehman Brothers was compelled to appraise properties at fair value following the accounting principle of mark-to-market value indicated in the Financial Accounting Standard n. 157. It is well known that at the moment of the crisis, the real-estate market cycle was interested by an impressive downturn. In this contribution, the necessity of a clear improving role of property market cycle in the valuation process is highlighted. On the third anniversary of its bankruptcy, Lehman Brothers remained the most important owner and seller in this property market segment in the largest and most transparent real-estate market in the world. In particular, the attention is focused on cyclical capitalization models that integrate income approach with the time series of the real-estate market cycle. In particular, as a possible solution that might help to change the attitude toward property valuation, in this part, we propose a generalization of the Cyclical Dividend Discount Model introduced previously in d’Amato (2001), d’Amato (2003), and d’Amato (2015). The main focus of the chapter is not to provide an exhaustive analysis of cyclical capitalization modeling but to show the weak and strong points of their application. At this stage, a few empirical applications are available, but according to the formal robustness of the models and the emergent role of property market cycle, especially after the nonagency mortgage crisis, they may give an added value to valuation prac- tice. More empirical applications can be provided only in a more transparent market where it is possible to collect net operating income (NOI) and price time series at a neighborhood level. Time-series analysis represents a necessary but not a sufficient con- dition to cyclical capitalization application. Price and rent forecasts may also be based on an expectation analysis. In both the cases, market transparency is a fundamental issue for a more professional and more sustainable real-estate market. e remainder of the paper is structured as follows. A brief literature review on real-estate market cycles is presented in the first section. An outline of the “classic” income approach method for real-estate valuation is given in the second section. In the third section, an introduc- tion to cyclical capitalization is offered, and in the fourth section, application to London office market data is discussed. Final remarks are offered at the end.