How does Zipf’s Law for Cities Affect Stock Returns? Evidence from Granular Risks in Commercial Real Estate

A growing literature investigates the “granular” origins of aggregate fluctuations in a variety of contexts. This paper builds on the theoretical framework developed by Gabaix (1999) and provides the first empirical evidence that agglomeration economies, derived from Zipf’s law of cities, are reflected in stock returns. We first construct a measure of idiosyncratic shocks to individual commercial real estate (CRE) markets, which we label granular property shocks (GPS). We show that this unexpected return risk in local property markets is subsequently capitalized into the prices of listed CRE companies. To establish a causal relationship between granular property shocks and stock returns, we adopt the Granular Instrumental Variable (GIV) approach recently developed by Gabaix and Koijen (2020, 2021). Our results suggest that idiosyncratic shocks from private CRE markets have a large and economically significant effect on listed returns: a one-standard-deviation shock to our instrumented granular shock increases quarterly returns by 1.34%, which is 40% of its mean value