An Investor’s Guide To Understanding the Location Quotient
Commercial real estate investors are always interested in the regional economy and geographic market where they own property or are thinking about investing. One of the best ways for investors to protect their invested capital and to ensure strong appreciation over time is to buy and hold property in markets that have a strong economic base and show signs of consistent economic growth in the coming years. One of the ways that investors do this is by analyzing the location quotient (LQ) in the market where they are investing. In this article we will discuss what the location quotient is, how to calculate it, and how investors can use it to gain a better understanding of the economic activity in their target market.
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What is the Location Quotient?
The location quotient is a metric that compares a particular characteristic or attribute in a location against the prevalence of that characteristic in a larger reference location. This usually means that a smaller region, such as a city, town, or county, is compared to a state or national average. In the context of commercial real estate, investors are usually concerned with the concentration of specific industry types and demographics in the local market compared to the national level.
LQ for Industries and Industry Clusters
It’s no secret that a city like Las Vegas is heavily concentrated in one industry – gaming, while another city like New York City is diversified across financial services, technology, retail, and so on. Understanding the nature of industry diversification allows investors to determine whether they want to invest in the market or alter their strategy to take advantage of any industry concentration in a metropolitan area.
Location Quotient for Demographics and Occupations
Similarly for demographics, investors need to understand the concentration of demographic types in their market relative to the national or state average. Then they need to think about how their investment will perform with the demographics of that market. For example, commercial properties housing high tech industries tend to perform well when situated near graduates coming from top-tier higher education institutions.
How To Calculate the Location Quotient
The methodology for calculating the location quotient is simple in theory but more complicated in practice. Let’s walk through the steps that an investor would take to calculate the location quotient one-by-one.
First, it’s important for investors to know the basic equation used to calculate the location quotient.
Location Quotient = Regional Data / National Data
While this may seem like a simple formula, there are a series of steps that need to be taken to know which numbers to plug in. Namely, getting the data requires research and reliable databases. Luckily for commercial real estate investors, the required data is usually available online for free in local, state, and federal online databases. Let’s take a closer look at some of the common data sources.
National Data For Calculating Location Quotient
Let’s start with national data. Finding national data is relatively straightforward because the U.S. Bureau of Labor Statistics compiles annual national employment data by industry at www.bls.gov. The BLS codes each industry using the North American Industry Classification System (NAICS), and this allows investors to see how many employees are employed in each industry. Similarly, the United States Census Bureau provides data on demographics at the national level at www.census.gov. Resources like these provide reliable data for comparison against the local market.
Local Data For Calculating Location Quotient
Obtaining useful data that captures employment across industry sectors in the local market can be harder to find. The BLS and Census Bureau offer some data for metropolitan statistical areas (MSAs). Investors can also turn to state and local employment data from local departments of labor for thorough, high-quality data.
Calculating the Terms of the LQ Equation
Once we settle on reliable data sources for national and local industry, employment, or demographic figures, we need to calculate two things before calculating the actual location quotient.
- First, we need to find the proportion of people in the nation who are employed in the industry or fit the demographic in question.
- Second, we need to do the same for the local market that we are studying.
Fortunately, the steps to do these calculations are basically the same whether using national or local data. It’s a matter of dividing the population within the geographic area that fits the parameter being studied by the total population in the geographic area. An example is helpful.
Let’s say an investor wants to explore the strength of the healthcare industry (specifically nursing) in Washington, DC compared to the national average. The investor would need to take the following steps:
- Calculate the percentage of jobs in Washington DC that are nursing jobs.
- Calculate the percentage of jobs in the United States that are nursing jobs.
The equations to find these percentages would look like this:
- Percentage of DC jobs that are nursing jobs = number of nursing jobs in DC / the total number of jobs in DC
- Percentage of US jobs that are nursing jobs = number of nursing jobs in US / the total number of jobs in US
Let’s apply real numbers to our example.
Let’s suppose that there are 735 nursing jobs and 720,000 total jobs in Washington DC. This means that about 0.1% of all the jobs in Washington DC are nursing jobs. The calculation is as follows:
735 nursing jobs in Washington DC / 720,000 total jobs in Washington DC = 0.1%
According to this equation, nursing makes up 0.1% of all jobs in Washington DC.
For the national proportion, let’s suppose that there are 53,000 nursing jobs in the US and 158.28 million total jobs in the US. This means that about 0.03% of all the jobs in the United States are nursing jobs. The calculation is as follows:
53,000 nursing jobs in the US / 158.28 million total jobs in the US = 0.03%
Note that these numbers are for the purposes of our example and do not represent actual figures.
The Final Step to Calculate the Location Quotient
Once we get the national and regional data and successfully calculate the percentage of the population that fits our criteria for both, we can calculate the location quotient.
In keeping with the example above, we now know that 0.1% of all the jobs in Washington DC are nursing jobs and 0.03% of all the jobs in the United States are nursing jobs. The location quotient calculation is shown below:
Location Quotient = 0.1% / 0.03% = 3.33
How to Interpret the Location Quotient
Now that we know how to calculate the location quotient, let’s discuss how to interpret it. The basic rule for interpreting the location quotient is as follows.
If the calculation returns a result less than 1.0, the regional area has less concentration or strength regarding a particular attribute than the national average. If the result exceeds 1.0, the regional location has a greater concentration or strength regarding a specific attribute.
To close out our example above, we calculated a location quotient of 3.33 for nursing jobs in Washington DC. This means that Washington DC is about three times more concentrated in nursing jobs than the United States as a whole.
What is the Location Quotient Used For?
Now that we know how to calculate and interpret the location quotient, it’s time to explain how commercial real estate investors can use it as part of the economic analysis and research they do prior to investing in a deal.
We mentioned earlier that location quotients can be used to analyze industry and employment concentration as well as demographic concentration. Let’s dive deeper into how an investor can plan their investing strategy or decide on an area of specialization based on the outcome of the location quotient calculation.
It’s no secret that certain markets are dominated by major industries and demographic trends. Earlier we mentioned that Las Vegas is dominated by the gaming industry, but other cities are dominated by the different segments within the manufacturing industry, business services, food services, or natural resources. Commercial real estate investors often decide to purchase asset types that fit with the industry makeup of the local market. So, for instance, in Las Vegas, hotels are a popular commercial real estate investment due to the strong tourism industry. On the other hand, in Detroit, manufacturing facilities tend to be more popular among investors.
Regardless of which market you are in, it’s important to think about where the job growth will come from and how to capitalize on it. It’s also important to think about what the economic impact would be if one of the major economic sectors in a local market were to suddenly struggle or cease to do business there.
The same can be said for demographics. In recent years, certain cities such as Nashville have seen strong population growth rates, especially among working age adults. Situations like this make for interesting case studies for investors because they can monitor the geographic area for employment growth, the strength of retail trade, and the ability of local governments to supply the infrastructure to accommodate the population growth. When all of these factors are working in investors’ favor, it can be a great time to invest in that market.
While location quotient is not a forecasting tool, some investors calculate it for several industries and occupations for a specific area over a particular time period. This helps investors to get a solid grasp on the following trends:
- Changing demographic trends in a region compared to the national average
- The supply and demand for certain jobs in a region compared to the national average
- The competitiveness of different industries in a region compared to the national average
Based on the results of this research, commercial real estate investors can build investment strategies that capitalize on changing trends in a given area. Using location quotient and other types of analysis, CRE investors can think about how the economic development of a particular market is going to play out. Initiatives like this also help investors to think about what kinds of job demands and industrial demands a region might develop in the coming years.
To summarize, the attributes that commercial real estate investors are most concerned with are industries, demographics, and employment. By definition, commercial real estate investors deal in office buildings, multi-use properties, retail centers, industrial complexes, and manufacturing facilities. Industry, demographic and employment data is crucial for understanding a region’s local economy. Understanding how a region’s job economy or retail industry performs compared to a larger region helps investors make well-informed, strategic decisions.
Drawbacks of the Location Quotient Analysis
Despite being a powerful analytical tool, location quotient does have some limitations that commercial real estate investors need to know about.
First, the quality of the output is only as good as the quality of the input data. If the data is not comprehensive enough, or if the scope or methodology behind the national data doesn’t quite align with the regional data, the results might not accurately reflect the actual market conditions.
Also, the datasets are sometimes too broad. The categories of industry listed in federal and state databases can actually contain numerous subclasses of industries. Consider, for example, that “healthcare” as an industry accounts for massive university hospitals, 24/7 emergency clinics, cosmetic surgery facilities, specialists’ offices, and pediatric clinics.
The location quotient is a powerful analytical tool, but it is not the only tool commercial real estate investors should add to their toolboxes.
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