Granular risks and stock returns: Evidence from commercial real estate

Abstract A growing literature investigates the “granular” origins of aggregate fluctuations in a variety of contexts. This article builds on the theoretical framework developed by Gabaix (1999, 2011) and provides the first empirical evidence of the causal link between granular risks, stemming from the size and geographic dispersion of cities, and stock market returns. We first construct an aggregated, firm‐level measure of risk, termed granular property shocks (GPS), based on idiosyncratic risks in each commercial real estate (CRE) market, weighted by the percentage of each firm's portfolio allocated to each market. 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 GPS and stock returns, we adopt the granular instrumental variable approach recently developed by Gabaix and Koijen (2024). Our results suggest that idiosyncratic shocks from individual property markets have a large and economically significant effect on listed returns: A one‐standard‐deviation shock to our instrumented GPS increases quarterly stock returns by 1.34%, which is 40% of its mean value.