Featured Faculty
Tsang, Desmond Tak-ming
Associate Professor
Co-Director, Centre for Hospitality and Real Estate Research
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When emerging cities offer better real estate returns
• 6 mins read
You have probably heard the old adage, “Don’t put all your eggs in one basket.” It’s sound advice, but knowing where to place your eggs is just as important
The Chinese economy has relied on real estate investment as a surefire path to wealth in the past decades. As real estate developers race to meet demands, especially before the market downturn, it is very common for them to spread operations and investments across different regions or cities. At first glance, this geographic diversification seems like a no-brainer. However, there is an ongoing debate about its benefits.
“High exposure of operations and investments to the more developed regions almost completely eradicates the benefit of diversification.”
Professor Desmond Tsang
Chinese real estate firms historically favoured investing in developed areas. Many highlighted advantages like better access to resources, while others mentioned drawbacks such as high operational costs and fierce competition. What is often missing from the discussions is that they often overlook the differences in economic and institutional development across various regions when making investments.
To address this discrepancy, Desmond Tsang, Associate Professor of Real Estate at the School of Hotel and Tourism Management at the Chinese University of Hong Kong (CUHK) Business School, conducted a study titled Geographic diversification and real estate firm value: Where firms diversify matter, joined by Chu Xiaoling of the University of Macau and Wong Siu Kei of the University of Hong Kong. This research seeks to investigate the association between geographic diversification and real estate firm value, and whether regional development gaps could heighten the cost of diversification.
“We found that the location of geographic diversification significantly impacts firm value, and a higher exposure to the developed Chinese cities reduces the benefit of geographic diversification,” says Professor Tsang, emphasising the importance of considering local institutional differences when assessing the expected benefits of diversification. These benefits include increased value, higher returns, and risk mitigation in case of economic downturns in certain areas, among others.
Developed regions aren’t always the best choice
The team conducted an empirical investigation by collecting data from the annual financial statements of 81 Chinese real estate firms between 2008 and 2018. These companies’ geographic diversification strategies are evaluated through their portfolio asset allocations to get to know which cities they had operations in and how many projects they had in each city. After discovering an initial positive relation between geographic diversification and real estate firm value, the researchers further explored the impact of differences in regional development.
To measure regional development, the researchers used the city momentum index (CMI) developed by a global real estate services firm, Jones Lang LaSalle. This index identifies “momentum cities”, where urban economies and real estate markets are undergoing rapid growth and development. Over the span of the sample period, 12 Chinese cities, including Beijing, Shanghai, Shenzhen, Guangzhou and Nanjing, were included in the index.
The analyses reveal that when firms invest or operate in developed regions with higher momentum, which means regions experiencing faster economic growth, the expected benefits of geographic diversification are significantly reduced. “High exposure of operations and investments to the more developed regions almost completely eradicates the benefit of diversification,” Professor Tsang says.
The reasons may lie in the intense competition for resources in these well-known urban hubs. “Despite the glamour, well-known superstar cities have highly competitive real estate markets, which sometimes offer lower returns,” he adds, underscoring that where firms choose to diversify their portfolio matters.
Driving factors for the negative returns
To further understand why diversification into developed regions fails to deliver anticipated benefits, the team break down the CMI into two components: socioeconomic and industry-specific factors. Socioeconomic factors involve aspects like gross domestic product, population growth, and foreign investment. Industry factors include changes in office space, rents, hotel occupancy, commercial real estate investments, and transparency.
The findings indicate that both factors contributed to the negative revenue of real estate firms that operated and invested in more developed cities. “We argue the growth of socioeconomic factors should enhance the demand of real estate but also engender institutional environment, while the growth of real estate industry factors might lead to more opportunities but at the same time more competition,” Professor Tsang says.
A strong institutional environment can provide stability and support for the real estate market but can also introduce challenges like increased competition and higher barriers to entry, i.e., obtaining permits, adhering to zoning laws, meeting environmental standards, and the like. The team then identified a more substantial negative impact of real estate firms investing and operating in cities that appeared on the CMI frequently, e.g., Beijing, Shanghai, Shenzhen, Nanjing, Wuhan, and Tianjin. The reduced benefits of geographic diversification were also more noticeable in cities with fast-growing real estate prices.
“These cities have gone through a prolonged period of rapid growth and development, which possibly led to market saturation and high competition that resulted in diminishing returns for the firms,” Professor Tsang adds. “Moreover, these cities are known to have better transparency and infrastructure, which could imply that firms might have greater difficulties in utilising nonmarket means, such as political connections and contributions, to secure resources.”
Less developed regions, higher returns?
Professor Tsang summarises that investing across different regions is beneficial in most parts of emerging economies like China, but competition for resources among firms in major cities begins to outweigh the advantages as some regions experience rapid growth, even surpassing rates seen in mature economies.
“Diversification into the less developed regions remained a viable option to enhance firm performance,” he says, “Despite higher transaction costs associated with these regions, we showed diversified firms could reap the benefit of diversification.”
Higher transaction costs translate to more uncertainty regarding contract enforcement, inadequate infrastructure, and a lack of legal protections and enforcement mechanisms. Professor Tsang notes that companies can succeed by efficiently shifting their resources in places with weak institutional environments and minimising transaction costs through nonmarket means to influence policymakers to retribute resource allocations in their favour. As a result, transaction costs in these regions might not necessarily be higher compared to those in more developed regions.
In addition, real estate firms should be more prudent in their investments regardless of their chosen location or diversification strategies. “Firms can consider other initiatives, such as the inclusion of green and well buildings in their portfolios, which would be more apparent for investors of the developed regions,” Professor Tsang suggests.
“We believe different regions could offer different benefits, and there are comparative advantages in offering a more diversified property portfolio across different regions, instead of chasing only the ‘superstar’ cities such as Shanghai and Shenzhen.”
