Ever wonder why investors shell out billions for trophy office towers even if cap rates are minuscule? One reason is that they tend to be more profitable than smaller buildings in the medium run.
Index provider MSCI dug into annual real estate return data and found that bigger, more expensive buildings outperformed their smaller peers globally in 17 out of the past 18 years (see chart). The catch: the one year they didn’t was 2016, and time will tell whether this is the beginning of a new trend.
MSCI’s analysis only compares buildings within the same country and asset class. It found that based on historical performance properties in the most expensive quartile have a 53.2 percent chance of outperforming other assets in their country and sector, compared to a 43.5 percent chance for this in the least expensive quartile.
It may sound puzzling that larger buildings outperform smaller ones over such a long period. After all, wouldn’t investors get wind of this after a while and start paying more for bigger towers until the returns are about even? One possible explanation is that there simply aren’t that many firms that can pay $500 million for a single building, which keeps a lid on prices. “Buyers are limited by size and capacity constraints,” MSCI notes.
But higher returns also come with a downside. “Adding larger assets to a direct portfolio can increase concentration risk and leave the portfolio more exposed to asset-specific performance,” MSCI notes.