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You could argue that the difference in returns between each real estate asset class and the 10-year Treasury constitutes a risk premium. The theory in using the 10-year Treasury as the baseline is based upon the belief that this investment is the safest in the world, backed by the full faith and credit of the United States.
As indicated in Table 2, however, investors have been requiring that apartment properties return 356 basis points more than the 10-year Treasury.
Looking at risk premiums
Now let's look at how current capitalization rates and risk premiums for each real estate asset class compare to historical trends. The data in Table 3 (below), which is from the third quarter of 2006, comes from studies of initial capitalization rates conducted by the Real Estate Research Corp. and published by the Urban Land Institute.
Risk premiums for each real estate class are tracking better than historical risk premiums, with the exception of apartments. In some markets -- Southern California, for example -- Class A apartment capitalization rates have been as low as 5.5 percent, shrinking the risk premium even further.
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