Is investors’ preference for them warranted?
An important issue for investors is that of how to structure their exposure to commercial real estate. A common allocation strategy is to tilt real estate portfolios towards well-located, high-quality properties in economically important markets, such as New York, Tokyo or London (ie, gateway markets). Several economic mechanisms can provide grounds for explaining the preference of investors for gateway markets. Large cities should have higher economic productivity, which translates into production factors (both human and physical) being more valuable and exhibiting higher appreciation rates. This reasoning applies to commercial properties, as they constitute an important production factor. This should be particularly true for the office and industrial sectors. For residential and retail properties, the effect is likely to be more complex given that higher wages can be allocated to other items than sheltering and consumption. However, the benefits of holding a large exposure to gateway markets have not been well documented so far.
Our latest research paper (Hoesli, M. and L. Johner, 2022, “Portfolio Diversification Across U.S. Gateway and Non-Gateway Real Estate Markets”, Journal of Real Estate Research, Available in open access at https://doi.org/10.1080/08965803.2022.2038902) intends to fill this gap by isolating the impact of macro-location quality, ie, gateway versus non-gateway markets, on real estate performance. For this, we use a large database of institutionally owned commercial real estate holdings in the United States graciously made available to us by the National Council of Real Estate Investment Fiduciaries (NCREIF) and covering the period 2004-2019. This permits us to investigate the effects of macro-location on commercial real estate return and risk characteristics using over 310,000 data points, representing more than 14,000 properties across 254 metropolitan areas. This is undertaken for the four main sectors (ie, office, retail, apartment and industrial). Following common wisdom, we use New York, Los Angeles, Chicago, Washington DC, Boston and San Francisco as gateway markets.
For the period under review, gateway markets have higher total returns (8.4% vs 7.7%) than their non-gateway counterparts, but those returns are also more volatile. The higher variability of returns in gateway markets is not attributable to differences in systematic risk, which is comparable across market types, but rather to the idiosyncratic nature of the market. This is surprising, as one would have expected gateway markets to be more tightly connected to widespread shocks in the economy.
Figure 1: Appreciation and income returns for varying levels of exposure to gateway markets
