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

Abstract:     
We estimate the cross-sectional dispersion of returns and growth in net operating income (NOI) of apartments, industrial, retail and office properties using panel data for U.S. metropolitan areas over the period 1986 to 2002. Cross-sectional dispersion is a measure of the total volatility faced by investors in commercial real estate. To the extent that most of that volatility is difficult to diversify, cross-sectional dispersion may be an appropriate measure of risk. We document that for apartments, industrial, retail, and office properties, the cross-sectional dispersions are time-varying. Interestingly, their time series fluctuations can be explained by macroeconomic variables such as the term spread, default spread, inflation, and the short rate, which capture macroeconomic fluctuations. The total volatilities are counter-cyclical and also exhibit an asymmetrically larger response following negative return shocks, which might be due to leverage and credit channel effects. Finally, we find a positive relation between future returns and their cross-sectional dispersion. This total risk-return trade-off suggests that investors indeed demand compensation for being exposed to total volatility in the commercial real estate market.

Keywords: Commercial real estate, cross-sectional volatility, total risk

JEL Classifications: L85

Working Paper Series