The latest study by EPRA shows the effect of the credit crunch on correlations between listed real estate and other asset classes. Jeff Rupp speaks to Steffen Sebastian about the importance of these trends when looking to diversify multi-asset portfolios
Extreme volatility in financial markets and plunging asset prices have pushed investment diversification in portfolios to the top of asset allocators' agendas, and real estate stocks have a key role to play in this riskier world, research by the European Public Real Estate Association (EPRA) shows.
The latest research is an update of EPRA's ‘Investor Outreach Study - Correlations of Property Stocks with other Asset Classes'. The study was carried out by Steffen Sebastian of the International Real Estate Business School at the University of Regensburg in Germany.
"Investors generally consider three major factors as they develop their portfolio diversification strategy - the expected return, the risk, and the correlation of the primary assets to other asset classes," Sebastian explains.
"Besides a positive return and an acceptable level of risk, low or even negative correlation is the most important factor that investors look for in the diversification of their portfolios," he says.
"Since the credit crunch started, all asset classes have been on a roller coaster ride and no one can be certain what's around the next corner. With returns and risk being highly volatile and unpredictable, diversification becomes more important than ever to investors. If several asset classes have the same risk/return profile, the asset class with the lowest correlation to the primary asset classes is the best diversifier," he adds.
Studies have shown that property stocks significantly improve the risk/return profile of a mixed asset portfolio because of their low or negative correlation to other asset classes, but the correlations vary over time and geographical markets.
The EPRA study investigated rolling five-year correlations between the quarterly returns of the FTSE EPRA/NAREIT Global Real Estate Index series and traditional asset classes - equities, corporate bonds, money markets and government bonds, as well as emerging market stocks, direct real estate, private equity and venture capital, hedge funds, and commodities.
The update of the study, first published in early 2007, now incorporates data from the first months of the credit crisis through to the first quarter of 2008. The study shows that after the credit crunch started the volatility of correlations between investment assets increased, like most other market measures.
"But correlations don't change that dramatically over time and are much more stable than returns. The data from the months after the credit crunch started offers fascinating insight into how correlations of property stocks to other asset classes behave in this turbulent environment," Sebastian says.
The original EPRA study showed that real estate stocks were a particularly interesting diversifier for investors in government bonds from 2000 onwards, and that relationship generally holds true in the updated research, although US Treasuries have moved to a more positive correlation since the onset of the financial crisis, while European sovereign debt has remained largely in negative territory.
While it is not possible to draw a direct causal link from a correlation study, there did appear to be some connection between this relationship and the decline in global interest rates from 2000, which may have been disrupted, in the case of the US, by recent events.
Corporate bonds are also an interesting diversifier for property stocks, with a particularly negative relationship in 2003 and 2004. Since that time, the correlation between the two markets has increased, so while real estate equities are still potentially a relatively good diversifier with corporate debt, they are not as good as they have been. The most recent data, however, shows the correlation between the two dropping towards zero again, so the previous trend may be resurrecting itself.
Since the last study, property stocks have shown a sharp decrease in correlation with general equities, at least through until the end of 2007. As the financial crisis took hold, the trend reversed itself in the first quarter of last year, perhaps indicating that all equity sectors were equally overwhelmed by the titanic forces hitting the markets.
Sebastian observes that in previous stock market routs, such as in 1987 and 1991, real estate investment trusts had performed relatively better than general stocks, possibly pointing to the advantage of having a tangible physical asset underpinning property share price values. These certainly seem to be natural buffers for property shares as they develop steep discounts to net asset value and the attractions of being taken private loom larger, he adds.
There is evidence in the study to indicate that property stocks' correlation with emerging market stocks is dropping. Sebastian warns, however, that conclusions should be drawn carefully, especially because the correlation trend was not the same in all property stock markets, most notably Australia. He explains that in some ways
Australia seems to be a special case, which may be related to the different performance of its economy relative to other developed economies.
The study also shows evidence that property stocks' correlation with direct real estate is falling, but Sebastian again cautions against drawing hasty conclusions: "The only thing you can definitely say about that is that the property stock market is even more different from the direct property market - meaning less integrated - than it used to be.
Of course, this analysis is based on two alternative valuation measures and should not be taken taken too seriously. I think that property stocks react rapidly to market information and this results in volatility - property stocks obviously react to news and developments in the market far more quickly than the direct property market does," he says.
Correlation data between property stocks and private equity and venture capital was generally stable in the latest period and, although positive in most markets, the strength and direction of slight correlation trends varied between them. Hedge funds continued to show a positive correlation, although the strength of that correlation declined in the most recent period, indicating an improvement in their diversification potential. As in the earlier study, property stocks' correlation with commodities is close to zero, indicating that there is no relationship between property stocks and commodities, either positive or negative.
"Any blanket statement that a single asset class always offers optimal diversification benefits with any other should be viewed sceptically," says Sebastian. "There is no ideal asset allocation strategy. It depends on the investment horizon and lots of other factors.
Nevertheless, property stocks continue to offer interesting diversification potential for several major asset classes, and investors need to consider this when they're developing their diversification strategies. With diversification playing an increasingly prominent role in current market conditions, paying close attention to correlations has become even more important."