The "Cap Rate," 1966-1984: A Test of the Impact of Income Tax Changes on Income Property

Abstract

Recently, Fisher, Lentz, and Stern (1984) simulated the impact of federal income tax changes on investment in nonresidential real estate. Their paper and others have identified the impact that past and proposed income tax changes had, or will have, on real estate by simulating the impact of tax changes on cash flows. Current discussions of the likely impact of potential tax reform utilize similar partial equilibrium techniques that probably exaggerate the impact of tax changes.' No one has looked at the actual impact past changes have had on real estate investment returns. This paper will test the statistical impact of past tax changes on one estimate of real estate capitalization rates (cap rates). Fisher, Lentz, and Stern illustrated the impact of income tax changes on the rent-tovalue ratio, which is the cap rate in real estate terminology. The cap rate is equal to the net operating income divided by value, where net operating income is gross potential income less vacancy and collection loss allowance and less operating expenses excluding financing costs and income taxes. In this paper a model of the changes in the cap rate for income property from 1966 through 1984 will be developed and used to show the impact of two tax law changes: 1976 and 1981. The 1976 law caused construction taxes and interest to be