Story time: A tale of growth, volatility and risk-adjusted return
An important principle in finance is arbitrage, the tendency for capital to flow in the direction of higher risk-adjusted returns so that in equilibrium, when the flows stop, expected risk-adjusted returns are the same across all assets, including U.S. Treasuries, core real estate and development. Real estate is a hybrid asset consisting of a bundle of attributes that do not trade separately. However, the market will implicitly price those attributes such that the risk-adjusted return of each attribute is the same across properties and markets. Of course, markets are never in equilibrium, and the arbitrage efficiency breaks down in low transaction markets, but, in general, markets grope toward equilibrium. Let’s apply this principle to some stories that are part of the institutional investing lore.
Gateway cities offer superior returns
Gateway and non-gateway cities should exhibit the same risk-adjusted returns due to arbitrage; the market efficientl