Private Real Estate as a Portfolio Diversification Tool

Written by: Joe Pendon

Many savvy investors look to diversify their portfolios beyond traditional paper assets such as stocks and bonds. The objective of a diversification strategy is to have a variety of uncorrelated investment vehicles within a portfolio, such that losses in one asset class will be offset by gains in another class. The following data demonstrates the diversification strength of private real estate in a portfolio. It highlights the fact there is little correlation of private real estate with the stock and bond markets.

The graph below shows the performance for the 20 worst quarters of a typical 60% stock, 40% bond portfolio paired with the corresponding performance of private real estate from 1978-2012. The negative returns are demonstrated in the bottom half of the graph.  Real estate was down in only 3 of the quarters when the 60/40 portfolio was down. In 17 of the 20 quarters, private real estate generated positive returns when the 60/40 portfolio was down.

Source: NCREIF, Barclays Capital, Wilshire, JP Morgan Asset Management. Wilshire 5000 used for stock portfolio return, and Barclays Capital Aggregate Bond Index used for bond portfolio return. NCREIF ODCE Index used for private equity real estate return.

The correlation coefficient is another way to analyze real estate performance against the stock market. This is a mathematical relationship which demonstrates how closely two variables move in relation to one another. When two variables move in the same direction all the time, the correlation coefficient is 1 (perfect positive correlation). When two variables move directly opposite of each other, the correlation coefficient is -1. Values closer to 0 indicate that the two variables have little correlation with each other.

A study from the University of New Hampshire analyzed the correlation coefficients for real estate vs. the stock market for the thirty periods 1983 – 2012. The national property price index (NPI) represented private real estate, and the stock market was represented by the S&P 500. Data was analyzed for publicly traded REITs as well, represented by the US REIT Composite. The results are as follows, provided in both 5 year intervals and overall:

30 year Correlation: Stock Market, Public REITs and Private Real Estate

From the data above, the correlation coefficient for the NPI and the S&P 500 over the thirty year period is 0.13, indicating a low correlation between real estate and the stock market.  This underscores the fact that real estate tends to move independently of the stock market.

Unfortunately, Real Estate Investment Trusts (REITs) are not as independent from the stock market as private real estate. REITs trade on major stock exchanges and invest in real estate directly. They are in essence, real estate-flavored stock. Because they trade on a daily basis, they are subject to greater market volatility and are more closely correlated with the broader equity market. Over the past twenty years, the correlation of REITs with the stock market has gradually increased, demonstrated by the increasing correlation coefficient. The correlation of REITs over the thirty year period was 0.45, and it reached as high as 0.86 (during the period of the global recession).

These studies demonstrate private real estate as an asset class has been highly uncorrelated to the stock market. It is not subject to the same volatility, nor does it move in step with the stock market. The high risk-adjusted returns, coupled with its low correlation to a typical paper asset portfolio make private real estate an attractive diversification tool for investors.