Employment Growth and Real Estate Return: Are They Linked?
Liang, Youguo, McIntosh, Willard, Journal of Real Estate Portfolio Management
Executive Summary. Real estate returns and employment growth rates over the 1983-1997 period for forty-six major MSAs are used to examine the relationship between employment growth and real estate return. The results suggest: (1) Employment growth contributes to real estate return only in the short term. There is no relationship between expected return and employment growth over the long term (e.g., ten years). Employment growth, however, tends to reduce return beta and return volatility. (2) Employment beta and volatility are positively linked, respectively, to return beta and volatility. (3) Both employment beta and return beta are priced in the marketplace, that is, a larger beta is likely to be associated with a higher expected return. To investors, this study confirms the validity of employment analysis for investment decisionmaking because employment growth characteristics are related to return characteristics. Investors, however, are cautioned against aggressively pricing employment growth into their ten-year IRRs, especially for a longterm investment.
This study examines the relationship between employment growth of a metropolitan area and its property market performance. It is motivated by the fact that real estate investors tend to equate growth with superior return, or at least they tend to justify investments on the basis of employment growth. In addition, there is more and better information available on the dynamics of employment growth than on private real estate returns. If there is a linkage between certain characteristics of real estate return and those of growth (e.g., employment beta and return beta), detailed analysis of employment growth can be justified to support investment decisionmaking.
One might think that employment growth generates superior returns in real estate investment because employment growth tends to result in rental growth and thus rising valuations. Employment growth is a demand measure, reflecting only one dimension to the complex market dynamics. Construction determines supply. Demand and supply together drive rental changes, which, in turn, influence capital flows that change property valuation.
The truth behind employment growth and rental growth is more complicated, which is to say that in real estate investment, growth may or may not suffice, in itself, as a driving factor to deliver superior returns. For instance, it is sometimes the case that construction outstrips demand generated by employment growth, resulting in a negative relationship between real estate value and employment growth. Alternatively, construction sometimes trails growth-driven demand, as projected growth is typically discounted by uncertainty, allowing for positive value appreciation. In short, the relationship between employment growth and return can be positive or negative depending upon the circumstances.
If the real estate market is efficient, markets with high employment growth will be priced to the level that any abnormal returns will be eliminated. The concept of market efficiency, however, is not particularly convincing to many real estate investment professionals. The private real estate market, many of them believe, is highly inefficient. Therefore, a relationship between employment growth and real restate return cannot be formulated based on market efficiency.
An examination of real estate return and employment growth is helpful because it is much easier for investors to comprehend the economic dynamics of a city. For example, employment growth and volatility, and employment beta of an MSA are readily available from any of the economic forecasting firms. These statistics will be able to assist investors in formulating their investment strategies if and only if they are related to real estate returns.
DATA AND HYPOTHESES
The National Council of Real Estate Investment Fiduciaries (NCREIF) has been compiling the NCREIF Property Index since 1978. …