UK - Real estate provides diversification but its relationship with equity markets could be more complex than previously thought, according to a report published today by the Investment Property Forum (IPF).

The report examined why the stock market and commercial property in the UK fell simultaneously at the onset of the financial crisis and found a higher-than-expected probability that negative returns on equities and real estate would occur simultaneously - although this effect changes over time.

The research team, including professors Colin Lizieri and Jamie Alcock of Cambridge University, found that listed real estate responded quickly to shocks in the equity markets, while private real estate responded more slowly but with more persistent effects.

"Both are influenced by the performance of financial assets, but their returns are by no means fully explained by equity and bond returns. Thus, inclusion of real estate in a mixed-asset portfolio is likely to improve the risk-adjusted performance of that portfolio," said the researchers.

The implication is that real estate funds that do not rebalance their portfolios on a daily basis should focus on relationships between property and other assets over time - and to expect less diversification than existing approaches suggest.

The researchers said current models for managing real estate risk were unlikely to be up to the task because they assumed stable relationships over time. They also found that appraisal-based direct property indices could understate market risk in extreme markets.

"Standard portfolio management models that rely solely on mean return, on standard deviation and on a constant correlation between real estate and other assets may fail to capture all the dimensions of risk. The time-varying relationship between assets and the sensitivity of real estate returns to wider market conditions need to be taken into account," they concluded.