Are REITs and real estate the same thing? The latest research suggests they are, writes Martin Hoesli
Although the issue of whether real estate securities behave as real estate or as stocks is of importance to a large number of investors, no clear-cut conclusion can be found in the extant literature. Research conducted by Elias Oikarinen and I provides further empirical evidence on the issue. In particular, it examines whether securitised real estate returns reflect direct real estate returns or general stock market returns over the long horizon using international data for the US, UK and Australia. In our study, ‘long horizon’ or ‘long term’ refers to an investment horizon of three to four years, as this horizon is typically relevant for fund managers. This is also the horizon at which the dynamic interdependences between the assets appear to converge (at the latest) to their long-term values.
In contrast to previous research, which has generally relied on overall real estate market indices and neglected the potential long-term dynamics, our econometric evaluation is based on sector level data and caters for both the short-term and long-term dynamics of the assets. Moreover, we add leverage to direct real estate returns to make the direct market data more comparable with the REIT data. In addition to the real estate and stock market indices, the analysis includes a number of fundamental variables that are expected to influence real estate and stock returns significantly.
The inclusion of market fundamentals in the models eliminates any indirect effects of these economic factors on the co-movement between the REIT, direct real estate and stock markets. It appears that our analysis is the first one on the theme that incorporates economic fundamentals and sector-level real estate data and caters for the short-run and long-run dynamics of the asset returns as well as for leverage.
Our findings suggest that securitised and direct real estate markets are tightly linked in the long run. It appears that REIT returns are largely independent with respect to shocks in the other assets – neither direct real estate nor stock market shocks appear to be driving REIT market performance.
However, a major part of the long-horizon forecast error variance of the direct real estate indices can be explained by REIT return shocks. This implies that the direct and securitised markets are closely linked and the predictability goes from REITs to the direct market – that is, ‘real estate shocks’ take place first in the REIT market, after which the direct market adjusts to them. In addition, the long-run reactions of REITs and direct real estate to shocks in the market fundamentals closely resemble each other, in general. The resemblance between REIT and general stock market dynamics is substantially weaker, whether a general stock or a small-cap stock index is used.
Consequently, while the short-term co-movement between REITs and stocks is typically stronger than that between REITs and direct real estate, REITs are likely to bring a similar exposure to various risk factors as direct real estate to a long-horizon investment portfolio. Therefore, REITs are also expected to have similar attractive diversification properties as direct real estate investments in the long horizon – that is, REITs and direct real estate should be relatively good substitutes in a long-horizon investment portfolio.
Our findings indicate that three years can be regarded as a ‘long horizon’ for portfolio analysis purposes. They have important implications with respect to asset allocation in a long-horizon multi-asset portfolio, since they point to opportunities for investors to combine the advantages of listed real estate with the attractive diversification features of direct real estate investments.
Our analysis also indicates that an investor should not reallocate his portfolio from REITs to direct real estate after a drastic drop in REIT prices caused by a financial crisis but, rather, to the contrary. Interestingly, while the sub-prime crisis affected the real estate sector more adversely than the overall stock market in the three countries, our findings indicate that the REIT market predicted the crisis and recovery.
Finally, the results are of relevance regarding the relationship between public and private markets in general, as the ‘duality’ of the real estate markets offers an opportunity to test whether and how closely securitised asset returns reflect the performance of underlying private assets.
Martin Hoesli is a professor at the Universities of Geneva and Aberdeen