Estimating the Cost of Equity Capital: Forecasting Accuracy for U.S. REIT Sector

Abstract

One of the fundamental concepts in financial economics is the cost of equity capital. The cost of equity is an important tool often used by a firm as a capital budgeting threshold for the required rate of return. The cost of equity of a firm also represents the compensation the market demands in exchange for owning the asset and bearing the risk of ownership. This paper focuses on the cost of equity capital estimates for a particular U.S. industry, the real estate investment trust (REIT) industry, to highlight the key role played by the choice of estimation method on the distant forecast. By using a comprehensive sample of 51 REITs over the period of January 1997 to December 2014, we compare the “hybrid beta” approach developed by Cosemans et al. (2016) with the Carhart four-factor model, the REIT-factor model in Chen et al. (2012) and the five-factor model formulated by Fama and French (2015). Our results demonstrate the superiority of the “hybrid beta” approach, which almost always produces, at the firm and portfolio-levels, absolute forecast errors that are lower than those of the other models implemented in our study.

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Keywords

Cost of Equity, Four-Factor, REIT-Factor, Five-Factor, Forecast Errors, Rolling Regression