The Cross-Sectional Dispersion of Commercial Real Estate Returns and Rent Growth: Time Variation and Economic Fluctuations

Abstract

We estimate the cross-sectional dispersions of returns and growth in rents for commercial real estate using data on U.S. metropolitan areas over the sample period 1986 to 2002. The cross-sectional dispersion of returns is a measure of the risk faced by commercial real estate investors. We document that for apartments, offices, industrial and retail properties, the cross-sectional dispersions are timevarying. Interestingly, their time series fluctuations can be explained by macroeconomic variables such as the term and credit spreads, inflation, and the short rate of interest. The cross-sectional dispersions also exhibit an asymmetrically larger response to negative economics shocks, which may be attributable to credit channel effects impacting the availability of external debt financing to commercial real estate investments. Finally, we find a statistically reliable positive relation between commercial real estate returns and their cross-sectional dispersion, suggesting that idiosyncratic fluctuations are priced in the commercial real estate market. IntroductionTime variation in equity risk and its relation to the state of the economy has been widely documented at both the firm and market levels (see, for example, Bollerslev, Chou, and Kroner (1992), Ghysels, Harvey, and Renault (1996), Campbell, Lettau, Malkiel, and Xu (2001) and Goyal and Santa-Clara (2003) among others). Comparatively little, however, is known about risk dynamics in the commercial real estate market and their link to prevailing economic conditions. * UCLA Anderson School and SAFE Center University of Verona, 110 Westwood Plaza, Los Angeles, CA 90095-1481, e-mail: alberto.plazzi.2010@anderson.ucla 1This scarcity of empirical facts is not due to a lack of investor interest. To the contrary, the commercial real estate market is large and represents a significant fraction of total U.S. wealth.For example, at year end 2004, estimates put the value of the U.S. commercial real estate market at $8 trillion as compared to the U.S. stock market's value of almost $18 trillion.We investigate risk dynamics in the commercial real estate market by evaluating the cross-sectional dispersions of commercial real estate returns and rental growth rates across U.S. metropolitan areas.The cross-sectional dispersion of commercial real estate returns is a more appropriate measure of the risk inherent in commercial real estate because it captures idiosyncratic fluctuations associated with this asset that are unlikely to be diversified away. Unlike equities, the commercial real estate market is characterized by the buying and selling of individual assets, the value of each property representing a non-trivial share of most investors' portfolios. This being the case, the volatility of aggregate real estate indices will not accurately reflect the risk exposure of a typical investor holding commercial real estate. Also, as commercial real estate tends to be affected by geographic, demographic, urban, and other local economic factors, the dispersion of commercial real es...

The Risk and Return of Commercial Real Estate: A Property Level Analysis

“…They find that the real estate factors well explain the cross‐section of the index returns. Plazzi, Torous and Valkanov () use biannual and quarterly appraised values of commercial property types over the period 1986 to 2002 from Global Real Analytics to construct the cross‐sectional dispersion of returns across 20–60 Metropolitan Statistic Ares (MSAs), and analyze the temporal variation of the dispersion. They find that macroeconomic variables help explain the time series fluctuation of the dispersion, and find a positive correlation between returns and the cross‐sectional dispersion.…”

“…Fama and French () show that the term spread is low near peaks of business cycles and high near troughs. Plazzi, Torous and Valkanov () suggest that business cycles may have a direct impact on commercial real estate values. For example, they argue, "An economic downturn with a corresponding reduction in employment and production lessens the demand for commercial real estate which, in turn, directly affects occupancy and lease rates.” Occupancy and lease rates directly affect income of commercial real estate and thus property values.…”

“…There are multiple reasons why the credit spread may relate to values of commercial real estate. For one, the credit spread may negatively correlate with the availability of external debt financing (see, e.g ., Plazzi, Torous and Valkanov ), and the credit availability has a strong effect on commercial real estate values (see, e.g ., Chervachidze and Wheaton , Arsenault, Clayton and Peng ). This indicates a negative relationship between the change in the credit spread and commercial real estate value appreciation.…”

Value versus Growth International Real Estate Investment

“…Although Plazzi, Torous and Valkanov (2008) find that the cross-sectional dispersions of commercial real estate returns are counter-cyclical (see also Ghysels, Plazzi and Valkanov 2007), such dispersions are not peculiar to real estate-they are true of most stocks and thus, do not detract from the relative certainty of rent compared to stocks' cash flow. Furthermore, Plazzi, Torous and Valkanov (2008) and Ghysels, Plazzi and Valkanov (2007) deal with commercial real estate as an entity rather than value versus growth commercial real estate. Similarly, Plazzi, Torous and Valkanov's (2010) findings that commercial real estate's expected returns and expected rent growth rates are time-varying and that cap rates forecast the expected returns for some commercial real estate relate to both value and growth commercial real estate-their paper does not address the real estate value premium anomaly.…”

“…Furthermore, Plazzi, Torous and Valkanov (2008) and Ghysels, Plazzi and Valkanov (2007) deal with commercial real estate as an entity rather than value versus growth commercial real estate. Similarly, Plazzi, Torous and Valkanov's (2010) findings that commercial real estate's expected returns and expected rent growth rates are time-varying and that cap rates forecast the expected returns for some commercial real estate relate to both value and growth commercial real estate-their paper does not address the real estate value premium anomaly.…”