The Changing Importance of Sector and Regional Factors in Real Estate Returns: 1987-2002

A stylized fact in the real estate diversification literature is that sector (property type) effects are relatively more important than regional (geographical) factors in determining property returns. Thus, for those portfolio managers who follow a top-down approach to portfolio management, they should first choose which sectors to invest in and then select the best properties in each market. However, the question arises as to whether the dominance of sector effects over regional effects is constant. If not, property fund managers will need to take account of regional effects in developing their portfolio strategy. Using monthly returns data for individual properties over the period 1987:1 to 2002:12, this paper investigates the influence of sector and regional factors on commercial real estate performance, first by adopting the dummy variable approach of Heston and Rouwenhorst (1994, 1995) and then by using the notion of cross-sectional dispersion introduced by Solnik and Roulet (2000). The results show that sector-specific dominate region-specific factors for the majority of the time and, in particular, during volatile periods of the real estate cycle. However, during calmer periods, sector and regional effects appear to be of equal importance. Overall, sector effects are still the most important aspect in the development of an active portfolio strategy.