Abstract
EXECUTIVE SUMMARY
This paper examines the time-varying nature of the relationship between real estate returns and other asset
classes. If the relation between assets varies across time, then use of a single static correlation or covariance to
inform portfolio selection may fail to provide investors with the diversification they expect;
Five data series are employed in this study: returns from UK property companies (the FT-EPRA UK series); private
real estate (the desmoothed IPD monthly index); the FT All Share index returns; returns from small-cap stocks; and
a UK government bond index. Data are collected monthly from 1990 to the end of 2010;
Overall returns statistics suggest that even after desmoothing, the IPD monthly index has a very low standard
deviation, below that of the bond return index. Direct private real estate’s low correlation with the other financial
assets implies considerable diversification potential. Public real estate returns, however, have positive correlations
with the overall equity market and small-cap stocks as well as weaker risk-return characteristics. While private real
estate seems to offer good mean-variance qualities for investors, the return distribution is negatively skewed and
has ‘fat tails’ – investors have a greater than normal probability of experiencing sharply falling returns;
A rolling correlation technique is employed to explore the evolution of the relationship between asset class
returns over the analysis period. It is evident that the correlations between public and private real estate and other
financial assets are not stable over time. Use of a single correlation to represent the relationship between pairs of
assets would, thus, be misleading;
The correlation between public and private real estate has been trending upwards from the mid-1990s, peaking
at nearly +0.7 in late 2008. The correlation between public real estate and the equity market has ranged between
+0.2 (at the end of the technology boom) and +0.8;
The correlation between property company and equity market returns initially fell in the financial crisis, then rose
again to the end of the analysis period; Private real estate’s correlation with the equity market has ranged between
−0.36 and +0.51 over the analysis period but with a general upward trend. As equity markets perform poorly, so
the correlation with real estate rises. This suggests that some of the presumed diversification benefits of real estate
will not be delivered when most needed;
The variation in property market returns is decomposed into elements that are explained by movements in the
returns of other assets and the element that is unique to real estate. In these factor models, the equity market beta
varies substantially over time, in part reflecting fluctuations in the influence of the stock market on property returns;
The influence of the equity market on property company volatility is considerably larger than the influence of the
underlying real estate market. However, during the global financial crisis, equity market influence on public real
estate volatility declined – and the influence of the underlying property market increased. While equity and bond
factors are significant in explaining the variability of listed property returns, from the mid-1990s, there exists a
significant idiosyncratic component that suggests that property companies do provide diversification benefits;
Far less of the variation in private real estate can be related to the equity, bond or small-cap factors, although the
degree of explanation varies over the analysis period. There is evidence that the financial assets have become more
significant recently, influenced by the financial crisis and continuing capital market problems;
Overall, the results suggest that there are significant financial market influences on the volatility of real estate
returns, in both public and private markets. Nonetheless, much of the variability in property returns is unexplained,
suggesting diversification benefits. The apparently greater independent component to private real estate might reflect
the specific nature of the direct market, but may also relate to the role of valuations in private property indices
This paper examines the time-varying nature of the relationship between real estate returns and other asset
classes. If the relation between assets varies across time, then use of a single static correlation or covariance to
inform portfolio selection may fail to provide investors with the diversification they expect;
Five data series are employed in this study: returns from UK property companies (the FT-EPRA UK series); private
real estate (the desmoothed IPD monthly index); the FT All Share index returns; returns from small-cap stocks; and
a UK government bond index. Data are collected monthly from 1990 to the end of 2010;
Overall returns statistics suggest that even after desmoothing, the IPD monthly index has a very low standard
deviation, below that of the bond return index. Direct private real estate’s low correlation with the other financial
assets implies considerable diversification potential. Public real estate returns, however, have positive correlations
with the overall equity market and small-cap stocks as well as weaker risk-return characteristics. While private real
estate seems to offer good mean-variance qualities for investors, the return distribution is negatively skewed and
has ‘fat tails’ – investors have a greater than normal probability of experiencing sharply falling returns;
A rolling correlation technique is employed to explore the evolution of the relationship between asset class
returns over the analysis period. It is evident that the correlations between public and private real estate and other
financial assets are not stable over time. Use of a single correlation to represent the relationship between pairs of
assets would, thus, be misleading;
The correlation between public and private real estate has been trending upwards from the mid-1990s, peaking
at nearly +0.7 in late 2008. The correlation between public real estate and the equity market has ranged between
+0.2 (at the end of the technology boom) and +0.8;
The correlation between property company and equity market returns initially fell in the financial crisis, then rose
again to the end of the analysis period; Private real estate’s correlation with the equity market has ranged between
−0.36 and +0.51 over the analysis period but with a general upward trend. As equity markets perform poorly, so
the correlation with real estate rises. This suggests that some of the presumed diversification benefits of real estate
will not be delivered when most needed;
The variation in property market returns is decomposed into elements that are explained by movements in the
returns of other assets and the element that is unique to real estate. In these factor models, the equity market beta
varies substantially over time, in part reflecting fluctuations in the influence of the stock market on property returns;
The influence of the equity market on property company volatility is considerably larger than the influence of the
underlying real estate market. However, during the global financial crisis, equity market influence on public real
estate volatility declined – and the influence of the underlying property market increased. While equity and bond
factors are significant in explaining the variability of listed property returns, from the mid-1990s, there exists a
significant idiosyncratic component that suggests that property companies do provide diversification benefits;
Far less of the variation in private real estate can be related to the equity, bond or small-cap factors, although the
degree of explanation varies over the analysis period. There is evidence that the financial assets have become more
significant recently, influenced by the financial crisis and continuing capital market problems;
Overall, the results suggest that there are significant financial market influences on the volatility of real estate
returns, in both public and private markets. Nonetheless, much of the variability in property returns is unexplained,
suggesting diversification benefits. The apparently greater independent component to private real estate might reflect
the specific nature of the direct market, but may also relate to the role of valuations in private property indices
| Original language | English |
|---|---|
| Publisher | Investment Property Forum |
| Number of pages | 40 |
| Publication status | Published - 2012 |