Regional economic diversification and cap rates: Evidence from the U.S. property market

Despite the existence of alternative, more sophisticated approaches, the capitalization rate (cap rate) constitutes the centre of practitioners’ evaluation of real estate assets to this date. A cap rate translates the current income of a property into a justified transaction price, considering both risks of the respective property as well as its growth opportunities. In light of the importance of the concept for practitioners world-wide, availability of recent academic research on the constituting factors of cap rates is rather sparse.Several existing studies focus on the intertemporal variance in cap rate time series (see for example Evans (1990), or Jud and Winkler (1995)). Another branch of research seeks to explain differences in the cap rate cross-section of different real estate sub-sectors (see for example Ambrose and Nourse (1993), Plazzi et al. (2010), or Beracha et al. (2017)). The third aspect evoking past academic research interest is the geographic cross-sectional variance of cap rates. Chichernea et al. (2008) use Real Capital Analytics (RCA) multifamily cap rate data and find a strong relationship to supply constraints for the cross-section of U.S. metropolitan statistical areas (MSAs). Fisher et al. (2021) perform an analysis on U.S. equity real estate investment trusts, showing that those companies with property portfolios in high-density areas have lower implied cap rates. Biakowski, Titman, and Twite (2023) find for the office sector that cap rates are lower for wealthier cities, and lower for CBD markets compared to suburban markets, utilizing data for 33 developed and developing countries.Taking up the existing research on geographic variance in cap rates, this study attempts to analyse the impact of economic diversification on cap rates. More precisely, the relationship between the degree of diversification across different NAICS industries in U.S. MSAs and the cap rates of the sub-sectors office, retail, industrial, and multi-family is studied. For this means, cap rate averages by sub-sector are regressed on a measure for economic diversification by MSA, using RCA transaction cap rate data as the dependent and NAICS industry diversification as the independent variable, along with a sample of controls in a panel framework for the time period between 2011 and 2022.Preliminary results suggest a negative relationship between economic diversification and cap rates, indicating real estate in MSAs with higher focus on specific industries are traded at a discount compared to real estate in diversified MSAs. Market participants seem to consider industry diversification as a systematic risk factor and therefor demand a premium for properties in well-diversified areas.