A groundbreaking study shows that “superstar cities” systematically lag in total returns—a crucial insight for valuing REITs (real estate investment trusts). The explanation lies in lower rental yields and surprisingly low risk, which fundamentally changes how future cash flows should be assessed.
For institutional investors, real estate allocation strategies seemed like a no-brainer for decades: focus on the “superstar cities.” Whether through direct investments or via REITs and property companies with portfolios in London, New York, or Tokyo, these global metropolises were seen as the undisputed engines of capital growth. The mantra was simple: invest where talent and capital flow, and price appreciation will follow.
A recent in-depth study published in The Journal of Finance, titled “Superstar Returns?”, forces us to rethink this paradigm. The researchers—Amaral, Dohmen, Kohl, and Schularick—analyzed a dataset spanning 150 years of real estate data. Their conclusion is both robust and counterintuitive: purely in terms of total return, investors would have done better over the past century and a half by staying outside the largest metropolises.
The core of their finding is that a one-sided focus on capital gains—that is, on rising Net Asset Value (NAV)—gives a distorted picture. Indeed, home prices in large cities rise faster in the long run. However, this advantage is entirely offset by significantly lower rental yields. Total returns are structurally almost 1 percent per year lower than in the rest of the country.
The figure below illustrates this perfectly. For nearly all cities studied, the positive contribution of capital gains (panel A) fails to outweigh the negative impact of lower rental yields (panel B), resulting in a lower total return (panel C) compared to the national average.
Figure: the difference in annual capital, rental, and total returns between major cities and the rest of the country (1950-2018).
Why, then, are investors willing to accept lower returns? The answer lies in the classic trade-off between risk and return. The study shows that real estate in large, diversified agglomerations is safer. Their economies are more diverse, markets more liquid, and property-level volatility lower. Investors thus “pay” for this safety in the form of a lower expected return.
The implications for analyzing REITs and property companies are profound. These findings offer a powerful framework for more accurately assessing the future cash flows and risk profile of listed real estate.
- Segment cash flow analysis: when valuing a REIT, it no longer suffices to look only at the total portfolio. A deep analysis of geographic spread is essential. A REIT heavily focused on residential property in “superstar cities” will likely generate lower but more stable and predictable rental income. The valuation of such a fund will depend disproportionately on expectations for capital growth (NAV growth).
- Identify the ‘cash flow kings’: conversely, a property company or REIT with a portfolio in secondary cities and broader regions presents a different profile. Here, higher direct cash flows from rent make up a larger and steadier share of total return. These portfolios are potentially more attractive for income-focused strategies and offer a better buffer in periods when capital growth stagnates.
The message for institutional investors is clear: a REIT’s geographic allocation is not a detail but a fundamental driver of its risk-return balance and the composition of its future cash flows. The “superstar city” funds serve as a stable, low-risk anchor. But for those seeking robust, income-driven returns, it pays to closely analyze funds that venture off the beaten path. The true superstars—in both physical real estate and the listed vehicles investing in it—often shine just outside the spotlight.
Gertjan Verdickt is assistant professor of finance at the University of Auckland and a columnist at Investment Officer.