AfterTheFall:RealEstateintheMixedAssetPortfoliointhe

AftermathoftheGlobalFinancialCrisis.

ColinLizieri
GrosvenorProfessorofRealEstateFinance
UniversityofCambridge
DepartmentofLandEconomy
19SilverStreet
CambridgeCB39EP,UK

Versionof29January2013:PleaseDoNotCiteWithoutPermission

Email:cml49@cam.ac.uk
Tel:+44(0)1223337114

The global financial crisis changed the perception of real estate as a risk diversifier in mixed asset
portfoliosasfallingrealestatecapitalvaluescoincidedwiththebearmarketinequities:privatereal
estateappearednotdeliverdiversificationwhenitwasneeded.AnanalysisofUKprivaterealestate
returns, desmoothed using a regimebased filtering process confirms that the relationship between
realestateandotherfinancialassetsistimevarying:butsuggeststhatthereremainstrongbenefits
fromincludingcommercialrealestateinthemixedassetportfolio.

1

After The Fall: Real Estate in the Mixed Asset Portfolio in the Aftermath of
theGlobalFinancialCrisis.

Abstract:

The global financial crisis changed the perception of real estate as a risk diversifier in mixed asset
portfoliosasfallingrealestatecapitalvaluescoincidedwiththebearmarketinequities:privatereal
estateappearednotdeliverdiversificationwhenitwasneeded.AnanalysisofUKprivaterealestate
returns, desmoothed using a regimebased filtering process confirms that the relationship between
realestateandotherfinancialassetsistimevarying:butsuggeststhatthereremainstrongbenefits
fromincludingcommercialrealestateinthemixedassetportfolio.

Keywords:PrivateRealEstate,MixedAssetPortfolios,DiversificationBenefits,TimeVaryingReturns,
VarianceDecomposition

RealEstateandtheGlobalFinancialCrisis

The recent global financial crisis may have changed investors perception of commercial real estate
as an asset class. Real estates position in the mixed asset portfolio has traditionally been justified
with reference to a combination of apparently favourable riskadjusted returns, inflation hedging
qualities and the benefits of diversification, based on ex post evidence of low correlation between
property returns and financial assets. An extensive literature exists that seeks to assess those
benefits and to explain the apparent mismatch between hypothetical allocations in a Markowitz
optimiser framework and the actual holdings of professional investors. Nonetheless, the evidence
appears to be consistent that adding private real estate to a portfolio of stocks and bonds is
expected to enhance riskadjusted portfolio returns and insulate the portfolio against drawdown
duringbearmarkets.

However,intheglobalfinancialcrisisthatbeganin2007,realestateperformedexceptionallypoorly
across different property types and locations in many countries. Moreover, correlations between
realestateandotherassetclassesappearedtoincreasemorethanduringotherrecentcrises,such
as the 199798 Russian and Asian financial panics. If the benefits of diversification offered by real
estatedonotholdinsharpmarketdownturns,perhapsduetoasymmetricreturndependencewith
other asset classes, then the gains from including real estate in a mixed asset portfolio may be
misplaced:asKnightetal.(2005)putit,doesrealestatedeliverdiversificationwhenithurts?Time
varying dependence between real estate returns and the returns from other asset classes under
would compromise results from standard optimisation exercises: expected portfolio returns might
be systematically overstated while risk particularly downside risk might be understated. As a
result,frequentrebalancingofinvestmentpositionswouldberequiredtomaintainachosentarget
levelofrisk,withsubstantialconsequencesforassetclassessuchasrealestatewithhightransaction
costs.

This paper contributes to the debate about the role of commercial real estate in mixed asset
portfolios in the aftermath of the global financial crisis by examining the changing relationship
between property returns and the returns of financial assets. The focus is on investment in private
realestatetheownershipofportfoliosofbuildingsfortheirrentalincomeandcapitalappreciation
rather than on investment in public listed real estate. The growth of private, unlisted investment
fundsacrossthe1990sandfirsthalfofthe2000smadesuchaninvestmentstrategymoreaccessible
for both professional and retail investors, previously constrained by lot size and capital entry
barriers.

While much recent research has focussed on dynamics or the asymmetry in the relationships
between asset returns or examined longrun relationships using VAR or VECM approaches
1
, this
paperadoptsamoredirectapproach,focussingonthetimevaryingrelationshipbetweenprivately
owned real estate and other financial assets that more closely linked to topdown asset allocation
approachesusingportfoliooptimization.Inpartthisisdrivenbydataissues:manyofthetechniques
usedinthecitedstudiesrequirehighfrequencydatathatareneitheravailableforprivaterealestate
nor necessarily appropriate when considering plausible risk management strategies for private real
estate investors. We examine correlation structures before and during the financial crisis and
decompose variation in real estate returns into distinct factors on a rolling window basis, the
window based on typical holding periods of professional investors. We analyse the relationship
betweenrealestateandotherassetclassesdirectly,ratherthanviaamacrofactormodel.

WeconductourempiricalanalysisusingUnitedKingdomprivatecommercialrealestatereturns.The
UK forms a valuable case study due to the availability of time series of reasonably robust monthly
investment return data from the Investment Property Databank monthly index. While the returns
from IPD are based on appraisals (and hence are subject to valuation effects), all assets in the
monthlydatabasearevaluedeachmonth(albeitlargelyonadeskbasedappraisalbasis).Moreover,
the overall size of the index is sufficient to provide some comfort that it is representative of the
overall behaviour of investment grade assets in the UK market. Nonetheless, it was necessary to
transformthedatatodealwithserialcorrelationandthepotentialpresenceofappraisalsmoothing
effects, using an innovative, regimebased desmoothing technique. More importantly, since the
majorityofthefundsreportingtotheIPDmonthlyindexareunittrusts,itis,inprinciple,investible,
by buying units in the largest funds subject to bidask spreads on entry and exit and potential
delaysinredemptionandtheimpactsofmodestgearingandcashholdings
2
.

Using a rolling window correlation approach, the time varying nature of the relationship between
privaterealestateandfinancialassetsisevident.Thereisclearevidencethat,inthefinancialcrisis,
correlationincreased.However,theriseincorrelationsis,innomeasure,acaseofallcorrelations
goingtoone.Weusefactormodelstodecomposethevariationinrealestatereturns,showingthat
theinfluenceofequityandbondreturnsvariesovertime.Theequityinfluenceonprivaterealestate
returns becomes stronger in the financial crisis, but never dominates: there still appears to be a
substantialdiversificationbenefitfromholdingrealestateassets.Theresultsalsosuggestthatlisted
real estate behaved more like private real estate and less like common equity in the financial crisis
phase.

The next section briefly reviews the extensive research on the role of real estate in the portfolio
before considering the implication of the sharp correction in real estate values in many developed
economiesinthelatteryearsofthe2000sforrealestatesplacealongsidefinancialassets.Next,the
data and the methods used are described. The fifth section sets out our empirical results: the final
sectionsummarisesthefindingsandconsiderstheimplicationsforportfolioriskmanagement.

PrivateRealEstateintheMixedAssetPortfolio

ThecaseforincludingrealestateinthemixedassetportfoliohasbeensetoutbyHudsonWilsonet
al.(2003)whosefirstreasonforinclusionistoreducetheoverallriskoftheportfoliobycombining
asset classes that respond differently to expected and unexpected events. Similarly, Chun et al.

1
Somerecentexamplesofanextensiveliteratureinclude,Boudryetal.(2012),Caseetal.(2012),Hoesli&
Oikarinen(2012),Liowetal.(2009),Lizierietal.(2012),Michayluketal.(2006),Oikarinenetal.(2011),
Stevensonetal.(2007).,Yangetal.(2012),ZhouandGao(2012).
2
Forexample,thequarterlypooledpropertyfundindexhasacorrelationof0.978withtheIPDmonthlyindex
between1989and2011andatrackingerrorofaround1.4%.
3

(2004) argue that real estate and real estate diversification pays off at the very time when the
benefits are most needed Analysing private commercial real estate returns alongside financial
assetsinaMarkowitzportfoliooptimizationframeworktendstosuggesthighallocationsfarhigher
than is generally observed in professional investment portfolios. There are many reasonsadvanced
forthismismatch:forexample,thattheallocationssimplyreflectmeasurementerrorandtheuseof
appraisalbased data; that reported returns do not account for illiquidity in private markets, or for
thehightransactioncostsofrealestate;thatitisnotpossibletoachieveindexedrealestatereturns
due to lot size, heterogeneity and capital constraints; or technical issues in the application of
portfoliomodelsconcerningdistributionalassumptionsandinvestmenthorizons.Nonetheless,even
wherethesefactorshavebeenaccountedfor,mostresearch,acrossawiderangeofcountries,still
findsthatcommercialrealestatehasaroletoplayinthemixedassetportfolio
3
.

Theonsetofwhathasbecomeknownastheglobalfinancialcrisisinthelate2000shadaprofound
impactonassetpricesinthemajorityofdevelopedeconomies.IntheUnitedKingdom,theFinancial
Times All Share total return index fell by 41% from October 2007, in the aftermath of the Lehman
BrothersfailuretoFebruary2009;UKsmallcapstocksfell59%fromOctober2007toFebruary2009;
andlistedUKpropertycompanyreturnsfell76%fromtheirpeakinDecember2006toMarch2009
or66%fromOctober2007.Privatecommercialrealestatewasnotimmunefromthesefalls.TheIPD
monthlycapitalvalueindexpeakedinJune2007.ItthenfelleverymonthuntilAugust2009,witha
peak to trough fall of 44%. The IPD monthly total return index, partially protected by the income
return delivered by investment property, still fell 37% peak to trough
4
. That listed and private real
estate performed so badly while equity markets were in a bear phase cast doubt on the claimed
diversification benefits of real estate as an asset class, raising the question: does commercial real
estatestillhavearoleinriskmanagementinthemixedassetportfolio?

DataEmployedintheStudy

Thecommercialrealestatereturnsusedinthestudyarethetotalreturnsforstandinginvestments
on the Investment Property Databank Monthly Index database (IPDMI). These are available from
December1986,althoughwebeginouranalysisinJanuary1990andendinDecember2011,giving
264observations.TheindexconsistsofthevalueweightedreturnsfromthosebuildingsontheIPD
databank that are valued on a monthly basis many of which will be properties that are in open
ended funds and unit trusts that require frequent regular appraisals since units are priced on a net
asset value basis. At December 2011, the index was based on returns from 3,595 properties with a
total capital value of 34 billion (US$55 billion). Over the analysis period, the index has grown as
morefundshavebeenvaluedonamonthlybasis:inDecember1989,theindexwasbasedonaround
1,700 properties. While it does not perfectly track the IPD Annual Index
5
, the Decemberto
DecembertotalreturnseriesfromIPDMIhasacorrelationof0.98withthemainindex.

The reported total return series is valuationbased and, hence, both income return and capital
appreciation are subject to appraisal effects. There is strong evidence of serial correlation in the
returns (although on a monthly basis that is not unreasonable, given the contractual nature of the
incomeflowsandthefiveyearlyrentreviewcyclethatistypicalofUKcommercialleases).Inusing
appraisal based real estate data, researchers have typically attempted to remove the impact of a
valuation updating process, initially identified by, inter alia, Quan and Quigley (1989), using some

3
RecentreviewsanddiscussionsincludeBondetal.,2007a,2007b,Chunetal.,2004;Hoeslietal.,2003,2004;
HoesliandLizieri,2007,MacKinnonandZahman,2009;Rehring,2012.
4
Bycontrast,UKowneroccupiedhousepricesfellonly22%peaktotrough:however,salestransactionsfell
dramatically,from110,000permonthin2006tolessthan49,000permonthin2008.
5
SeeCrosbyetal.(2010)foradiscussionofpossiblevaluationdistortionsrelatingtotypeofownership.
4

form of filtering process: for reviews see, for example, Fisher et al. (2003) Geltner et al. (2003),
Marcato&Key(2007)orLizierietal.(2012).
To correct for appraisal smoothing effects, we use the regimebased desmoothing procedure
introduced by Lizieri et al. (2012). This approach suggests that both the underlying return process
and the valuation effects may be timevarying, conditional on the underlying economic
environment.Forexample,there mayberegimeswheretheunderlyingmarketbehavesstablyand
others where there is considerable volatility; similarly, there may be periods where appraisal
smoothing is marked (for example when there is a dearth of transaction evidence), and others
whereitislessprevalent. Regimesareidentifiedusingadoublethresholdautoregressiveapproach
derivedfromTong().Theprocessisdescribedinmoredetailbelow.Lizierietal.suggestavarietyof
candidate variables to delimit the regimes, including GDP, employment, inflation, equity market
performance,interestrates,exchangeratesandvariousrealestatemeasures.Wefollowtheirpaper
in using equity returns to defining return and smoothing regimes. The impact of the process is to
reduce the first order serial correlation from 0.900 to 0.301 (similar to that found for our bond
returnseries)whilenearlydoublingthestandarddeviationofreturns
6
.

For equity market returns, we use the total returns for the Financial Times All Share index, the
broadest measure of equity market performance. For bond returns, we use an index of returns on
ten year maturity UK government gilts. To examine the impact of small capitalisation stocks, we
analyse the FTSE Small Cap Stock total return index. These series were sourced from DataStream.
Finally,weuseFTSENAREITEPRAUKpropertycompanyreturnseriestoprovideameasureoflisted
realestateperformanceforcomparison,obtainedfromEPRA.Wedonotcorrectforleverageinthe
EPRAindex,sincethereportedreturnsarethosedeliveredtoshareholders.

Exhibit 1 shows the performance of the indices over the analysis period
7
: descriptive statistics are
showninExhibit2.ThesharpcorrectionfollowingtheglobalfinancialcrisisisclearintheFTAS,EPRA
anddesmoothedprivaterealestateseries.Bycontrastthebondreturnindexperformsstronglyover
this period driven by the fall in yields that followed both Government intervention in bond and
moneymarketsandtheflighttosafetyasinvestors(domesticandforeign)soughtsecurehavensfor
capital.Exhibit3showstheyieldtomaturityforbenchmarkfiveyearGovernmentgilts,fallingfrom
anaverageof4.5%from2003to2008tobelow1%bytheendoftheanalysisperiod.Giveninflation
expectations of over 2% at that point, such yields offer negative real returns for a new purchaser.
However,thefallinyieldscreatecapitalgainsforexistingholdersofbonds,reflectedinthereported
returns.Theextremecycleofthelistedrealestatesectorisevident,inpartreflectingtheimpactof
leverageinboththegrowthandcorrectionphasesofthecycle.

Thedescriptivestatisticsconfirmthevisualimpression,withpublicrealestatedeliveringlowrelative
returns for high volatility; the low volatility and strong returns of the bond series means that any
conventional Markowitz portfolio optimised using a Sharpe ratio and with ex post data would be
dominated by Government securities
8
. There is evidence of nonnormality in the skewness and
kurtosisfigures,withtherealestateandsmallcapstockdistributionsbeingnoticeablyfattailed.We
also highlight the autocorrelation present in the desmoothed private real estate returns and in the
bond returns: this is not unexpected, in that these are total return indices with sticky contractual
incomestreams.

6
TheseresultsarebroadlyconsistentwiththefindingsofDevaneyandMartinezDiaz(2011)whoconstructa
transactionbasedindexforIPDquarterlyreturnsbasedontheFisheretal.(2003)modelandreportafallin
autocorrelationfrom0.77to0.39andanincreaseinthestandarddeviationofreturnsfrom4%to6.5%.
7
WeomitthesmallcapstockindexwhichcloselytracksFTAS.
8
Ontheotherhand,giveninterestsratesatornearthezerolowerbound,anexpectationsbasedapproach
mightfactorinrisingdiscountratesandpotentialfallingvalues.
5

Exhibit1.RealEstate,EquityandBondIndices19892011
Source:IPDP,EPRA,DataStream

Exhibit2.DescriptiveStatistics,RealEstate,EquityandBondMonthlyReturnSeries19902011
PanelA:DescriptiveStatistics
IPDDes EPRA FTAS SmallCap Bonds
CompoundGrowth 0.57% 0.24% 0.62% 0.46% 0.71%
MeanReturn 0.59% 0.42% 0.72% 0.60% 0.73%
StandardDeviation 1.93% 6.06% 4.28% 5.34% 2.05%
Skewness
1.4547 0.1296 0.4619 0.1470 0.0592
Kurtosis 6.4955 1.7353 0.5674 3.1213 0.9887
Autocorrelation 0.3018 0.1961 0.0904 0.2538 0.0393
SharpeRatio 0.080 0.001 0.067 0.032 0.147

PanelB:CorrelationCoefficients19902011
IPDDes EPRA FTAS SmallCap Bonds
IPDDes 1.000
EPRA 0.265 1.000
FTAS 0.160 0.624 1.000
SmallCap 0.205 0.629 0.813 1.000
Bonds 0.188 0.172 0.169 0.024 1.000
Notes: Panel A shows basic descriptive statistics for the monthly total returns of the Investment Property
Databank monthly index, desmoothed using the TAR approach (IPDDes); property company returns from the
FTSENAREITEPRAUKindex(EPRA),theFinancialTimesAllShareIndex(FTAS),theFTSmallCapStocksindex
(Small Cap) and a benchmark Government 10 year bond series (Bonds). Skewness and kurtosis measures are
zerocentred,autocorrelationisfirstorderserialcorrelationandtheSharperatioiscalculatedusingthemean
threemonthUKTreasuryBillrateoverthewholeperiodasaproxyfortheriskfreerate.PanelBshowsproduct
momentcorrelationsforthereturnseriesoverthewholeperiod.

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Exhibit3:TheFallinUKBondYieldstoMaturity

Source:BankofEngland

AnalyticMethods

Initially we analyse the data using a rolling bivariate correlation approach, using a sixty month
windowtoaccountforthelongerholdingperiodsofprivatecommercialrealestate.Thistechnique
allows us to observe changes in the correlation structure between pairs of asset classes over our
analysis period. Volatility in correlation would imply that a basic singleperiod covariance approach
to risk diversification may be misleading (if historic data are used as inputs); if there are apparent
structural shifts in the patterns of correlation, this might imply that there are different regimes in
which the diversification benefits of particular combinations of assets vary. There is some
relationship between volatility and correlation which needs to be considered in interpreting the
results.

Whiletherollingcorrelationanalysisallowsustoexaminethecomovementbetweenpairsofasset
classes, it necessarily ignores the interactions between all the different asset classes. If real estate
returns are, to some extent, linked to both equities and bonds and bonds and equities are
themselvesrelatedthenweneedtounpickthecombinedrelationship.Thissectionattemptstodo
thisusingafactordecompositionapproach.

Thebroadapproachhereistoestimateamodelofthegeneralform:

t Bt B SCt SC Et E REt
F F F R c | | | | + + + + =
0
(1)

where R
REt
is the real estate return for time t, the Fs are independent (orthogonal) factors
representing equities (subscript E), small cap stocks (subscript SC) and bonds (subscript B) and the
betas represent real estates sensitivity to those factors. The key here is that the factors are
unrelated orthogonal in an attempt to isolate the pure effect of a particular asset class on
propertyreturns.

Withsuchamodeldefined,itisthenpossibletoanalysetheinfluenceofeachofthefactorsonthe
overallvarianceofrealestatereturns,since:

2 2 2 2 2 2 2 2
i B B SC SC E E RE
o o | o | o | o + + + =
(2)

0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
Y
i
e
l
d

t
o

M
a
t
u
r
i
t
y

(
%
)
UKFiveYearBondRedemptionYield
7

whereo
2
isthevarianceoftheassetreferencedbythesubscript,thefinaltermbeingtheresidualor
idiosyncraticvariance
9
.Dividingeachproductbythetotalrealestatevarianceallowsustoestimate
the influence the variation in the returns on one asset class has on the variation in real estate
returns.Thus,theinfluenceofequityreturnvarianceonrealestatereturnvariancewouldbe:

%
2
2 2
RE
E E
o
o |
(3)

Tomodeltheinfluenceofdifferentassetclasses,factorswereconstructedusingtwoprocedures.It
isnecessarytocalculatefactorssincetherawreturnsarelikelytobecorrelated(forexample,theFT
All Share returns include returns that reflect real estate price movements and bond market
movements)whichcreatesestimationissuesandmaymasktheinfluencessought.

The first procedure used is that utilised by Clayton and Mackinnon (2003): to orthogonalise the
returnseriesbysuccessivelyregressingthereturnsfromoneassetclassontheothersandretaining
the residuals as a pure asset class factor as in equations (4), (5) and (6). Thus small cap stock
returns are regressed on the FT All Share index with the returns representing a small cap effect
purgedoftheoverallinfluenceoftheequitymarket.Next,bondreturnsareregressedontheFTAS
returnsandthesmallcapresidualstoproduceapurebondeffect;andthenrealestatereturnsare
regressed on FTAS and the small cap and bond residuals to yield a real estate series. We describe
thisastheresidualfactorapproach.

SCt FTt SCt

R R c | | + + =
1 0
(4)
Bt SCt FTt Bt
R R v c _ _ _ + + + =
3 1 0
(5)
REt Bt SCt FTt REt
R R u v c + + + + =
3 2 1 0
(6)

The problem with such a procedure is that there are ordering effects: in the model described, any
real estate influences on the overall equity market are retained in the FTAS returns
10
. The second
procedure, here described as the factor approach, by contrast, uses a factor analysis / principal
components approach to generate three factors that can represent bond, equity and real estate
performance that are uncorrelated, but not affected by ordering effects. First a broad set of index
returns and interest rate variables over the whole analysis period are analysed using a principal
components analysis which transforms a set of observations to produce orthogonal factors that
summarisethevariationinthedataset.Thosecomponentshavinganeigenvalueinexcessofoneare
retained and rotated to maximise the variable loadings on each factor using the varimax rotation
procedure to make interpretation clearer. Finally the individual factor scores from those retained
factors are retained and used as the independent (and, by construction, orthogonal) factors in
equation1.Inpractice,itdidnotprovepossibletogenerateasmallcapstockfactorusingthefactor
approachsothesmallcapeffectvariablefromtheresidualapproachwasusedwhereappropriate.

Withthefactorsconstructed,weonceagainexaminesuccessiveperiodsofsixtymonthsonarolling
basis. For each five year period, we calculate the betas of the factors and use these to decompose
the variation in the property returns into that explained by the equity market, small cap stocks,
bondsandrealestate.Iftheinfluenceof,forexample,theequitymarket,changesovertime,thenit
willexplainagreaterorlessershareoftherealestatereturns.

9
Thisholdssincetheexplanatoryvariablesareorthogonal,removingcovarianceterms.
10
Foramoredetaileddiscussionofissueswitharegressionbasedorthogonalizationmethod,seeBrooksand
Tsolacos(2000).
8

REt SCt Bndt EQt REt

F F R u c | | | | + + + + =
3 2 1 0
(7)

As in prior research, the direct private real estate returns, even after desmoothing, have typically
lowcorrelationswiththeotherassetclassfactorsandexhibitlaggingeffectswhichmeansthatthe
real estate factors dominate explanation. For that reason, we focus solely on the influence of the
otherassetclassesandtestdifferentlagstructures.FortheEPRApublicrealestatereturns,wecan
additionallyexaminetheinfluenceofthe(private)realestatefactor,sheddingadditionallightonthe
diversificationcharacteristicsofprivaterealestate.

The factor model testing revealed the presence of a lags in the response of private real estate to
changes in the defined asset market factors. Therefore, as a final set of tests, we examine leadlag
relationships between private and public real estate returns and the financial asset series using
Granger causality tests and use an unrestricted VAR model to observe the effects of shocks in the
property and equity markets on the subsequent performance of real estate returns, using an
impulseresponse framework. Since the main focus of the paper is on timevarying short run
relationshipsbetweentheassetclasses,weadoptstandardmethodsfortheseanalyses.

EmpiricalResults19902011

RollingCorrelations

In this section, we examine rolling 60 period correlation coefficients between real estate and the
othervariables,first,toassesstheextenttowhichtherelationshipsbetweenpropertyandfinancial
assetsaretimevarying,andsecondtotesttheassertionthatcorrelationsincreasedmarkedlyinthe
global financial crisis, such that the theoretical diversification benefits of real estate were not
delivered in practice at exactly the point when they would have been most beneficial. While five
years may seem a relatively low holding period for commercial real estate, Collett et al.s (2003)
studypointedtosharplyfallingholdingperiodsintheUKmarket,withamedianholdofsevenyears
at the end of their analysis period in 1998. Since then, the rapid growth of unlisted funds, many of
whicharefinitelife,hasprobablyfurtherreducedaverageholdingperiods.

Exhibit4showstherollingcorrelations.Itisevidentthattheyarenotstableovertime,althoughitis
not possible to distinguish between volatility effects and changes in the underlying relationships.
Panel A shows the correlations between FTAS and the desmoothed IPD series. To the turn of the
century these are low, often negative. They then begin to rise, stabilising at around +0.2. There is
thenasharpspikeupwards,peakinginOctober2008at+0.505.However,therollingcorrelationsare
plotted at the end of the time period. UK real estate values begin falling in August 2007: the peak
correlation thus includes 14 months of falling values and 36 months which coincided with the final
yearsoftheassetvalueboom.Asthisfallsaway,socorrelationsfallbacktoanewrelativelystable
levelaround+0.40.PanelBshowstheIPDDescorrelationwithSmallCapstocks:thepatternisvery
similartothatobservedfortheFTcorrelations.

PanelCshowstherollingcorrelationsbetweenthedesmoothedIPDseriesandthepublicrealestate
companyreturns.Inthefirsthalfoftheseries,correlationsareinsignificant.Theriseincorrelations
begins with the boom phase in asset values and continues across the financial crisis, peaking at
+0.720 in November 2008 and remaining above +0.50 until IPD capital values begin to rise in July
2009.Itappearsthatcorrelationsstrengthenedinboththeupanddownphasesofthemarketcycle.
Finally Panel D shows the correlations between IPDDes and the Bond series. The correlations are
lower, often insignificant with 58% of the correlations negative. In the financial crisis phase,
correlations become increasingly negative which can be related to the strong performance of
9

governmentbondindices,withpricerisesdrivenbyfallingyieldstomaturityfromgovernmentand
centralbankinterventionandfromflighttosafetyeffects.

Exhibit 5 shows, for comparison, the rolling correlations between the listed real estate returns and
the two equity market indices. Correlations fell in the dot.com and technology stock boom in the
late 1990s (in common with other value sectors) but rise across the asset value boom phase.
However, they fall sharply as the impacts of the global financial crisis hit equity and real estate
markets,fallingaslowas0.36inMay2008.ReferringbacktoPanelCofFigureY,thiscoincideswith
the increase in correlation between private and public real estate. From visual inspection, it seems
thatpublicrealestatebehavedmorelikeapropertyassetinthefinancialcrisis.Inthenextsection,
wedecomposethevarianceofassetreturnsoverthesamesixtyperiodwindowstoshedmorelight
onthisobservation.
10

Exhibit4:RollingCorrelationsBetweenRealEstateandOtherFinancialAssets

Notes: The Panels show rolling 60 month product moment correlations between the TARdesmoothed Investment Property Databank returns (IPDDes) and the three UK
financialassetvariables,theFinancialTimesAllShareIndex(FTAS),theFinancialTimesSmallCapStockIndex(SmallCap)andtheFTNAREITEPRAUKpropertycompany
series(EPRA).

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PanelD:IPDDes Bonds
11

Exhibit5:RollingCorrelationsBetweenListedRealEstateandEquityIndices

DecomposingtheVarianceofReturns

CreatingOrthogonalFactors

Exhibit 6 sets out the results of the orthogonalisation regressions using the residual approach as in
ClaytonandMcKinnon(2001).Thedegreeofexplanationfortheprivaterealestateseriesislowand
it was necessary to include lagged values of the equity market variable. While a critical
interpretation might suggest this is an artefact of measurement and index construction, it is worth
notingthattherealestateresidualhasastrong,positive,significantandcontemporaneouseffecton
listedpropertyreturns.

Exhibit6:OrthogonalisationRegressionsfromtheAssetClasses
Dependent: SmallCap Bonds IPDDes EPRA
Constant 0.001
(0.515)
0.006
(5.074)***
0.004
(2.637)**
0.002
(0.568)
FTAS 1.023
(15.815)***
0.093
(2.706)**
0.291
(a)
0.857
(10.832)
SmallCapResid 0.133
(3.191)**
0.061
(1.582)
0.414
(3.600)**
BondResid 0.163
(2.282)**
0.379
(2.232)**
RealEstateResid 0.565
(2.567)**

AdjustedR
2
65.8% 7.0% 1.4% 45.7%
FStatistic 482.275*** 10.384** 7.920** 52.953***
Notes:Othogonalisationregressionsforthedataseries,OLSwithWhitesheteroscedasticitycorrection.Figures
inparenthesisindicatetstatistics.(a)FTASbetaforIPDDesisaDimsonbetaoverthreelaggedmonths,jointly
significantatthe0.01level.Asterisksdenotesignificance,*0.05level,**0.01level,***0.001level.

0.000
0.100
0.200
0.300
0.400
0.500
0.600
0.700
0.800
EPRAFT EPRASC
12

To estimate the factor model, the return series for equities, the small cap stock series, EPRA UK
property company returns, private real estate (in both original smoothed IPD reported returns and
two desmoothed formats), bond returns and interest rate variables were subject to a principal
components analysis. Factors with eigen values in excess of one were retained, which were then
rotatedusingavarimaxprocedure(tomaximiseloadingsonindividualvariableswhileretainingthe
orthogonal qualities of the original component extraction). The analysis clearly identified three
variables: an equity factor, a bond/interest rate factor and a real estate factor (where the private
realestateloadingsweremuchhigherthanforEPRAwhichappearedtohavepropertiesmoreakin
to the equity indices). The factor scores for the extracted and rotated factors were retained as the
assetclassfactorsinsubsequentanalysis.

The first three factors explained 74% of the total variation of the eight variables included in the
analysis. Factor one explained 38% of variation and, after rotation, had strong positive loadings on
FTAS(0.903), Small Caps (0.890) and EPRA (0.817): it thus captures equity market behaviour. Factor
twoexplained24%ofthevariationandhadstrongpositiveloadingsonthetwodesmoothedseries,
thethresholddesmoothing(0.910)andconventionaldesmoothing(0.904)andtheunsmoothedIPD
returns (0.783); EPRA returns have a weak positive loading (0.178). This thus seems to be a direct
realestatemarketfactor.Finally,Factorthreeexplains12%ofvariation;theBondseries(0.549)and
LIBOR (0.866) load positively implying this is a bond/interest rate factor. By construction, all three
factorsareorthogonalanduncorrelatedinriskreturnspace.

PrivateRealEstateVariabilityandtheFactorModels

The optimal lag structure for the factor models lagged the equity and bond factors one period and
thesmallcapstockfactortwoperiods.Itisevidentthattheexplanatorypowerofboththeresidual
approachmodelestimatedusingequation6andthefactorbasedmodelestimatedusingequation7
increases markedly as the estimation window includes returns in the global financial crisis period.
Exhibit7showstheadjustedR
2
fromtherollingregressionswhichspikeupwardsforthemodelsthat
end in the second half of 2008 and remain at an elevated level thereafter. It should be stressed,
however, that even with that upward shift, the levels of explanation are low: a maximum value of
24.7%fortheresidualmodeland(intheGFCperiod)13.7%forthefactorapproach.Thetwomodels
differintheinfluenceoftheequitymarketandbondfactors.

Exhibit7ExplanatoryPoweroftheFactorModels

0.1000
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A
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ResidualApproach FactorApproach
13

Turning, first, to the factorbased model, the equity market factor beta is positive and statistically
significantforallregressionwindowsuntilmid1997:theaveragecoefficientis,however,just0.109.
FromthatpointuntilthewindowendinginDecember2008,itisstatisticallyinsignificant.Thereafter
itturnssignificantlypositivewithanaveragevalueof0.249,peakingat0.333inthewindowending
March 2009. The equity market betas are statistically significantly positive for 43% of the five year
windows. Exhibit 8 plots the evolution of the equity market beta factor. In the early part of the
analysis period, the bond/interest rate factor and the small cap residual factor betas are,
respectively, negatively and positively significant; in the financial crisis period, they remain
insignificant.

Exhibit 9 shows the influence of the equity market, small cap stocks and bond factors on the
variationinrealestatereturnsusingthefactorbasedmodel.Intheearlypartoftheseries,thethree
factors appear to have astronger influence, at times explaining some 30% ofreturn variation, with
equity, bond and small caps all playing a part. This influence declines, with adjusted Rsquared
figures declining to zero across the 2000s. There is a small spike upwards in the early years of the
century,perhapsassociatedwithassetpricefallsattheendofthetechnologystockboom.However,
attheendoftheanalysisperiod,astheimpactoftheglobalfinancialcrisisbecomesevident,initially
we see an increase in bond factor influence, rapidly replaced by a strong equity market effect. The
earlybondfactoreffectislinkedtonegativebetasandmaythusreflecttheinterestrateimpactsat
theendoftheboom/bubblephaseofrisingassetprices.Bycontrast,theequityimpactisdrivenby
positiveandrisingbetaswithequitymarketpricesfallingduringthefinancialcrisis(andthen,toan
extent,recoveringattheveryendoftheperiod)thissuggeststhattheeventsof20072009brought
morecommonmovementandlessdiversificationthanwasevidentoutsidethecrisisperiod.Thisis
emphasised by noting that the series of adjusted Rsquared for each of the windows has a 0.843
correlationwiththeannualisedpropertyreturnoverthewindow:thatistheinfluenceofotherasset
classes increases as real estate returns deteriorate. Nonetheless, the combined influence of the
assetfactorsonrealestatevariationneverexceeds20%inthefinancialcrisisphase,suggestingthat
thereremainsubstantialdiversificationbenefits.

Exhibit8:FactorBasedModel:EvolutionoftheEquityFactorBeta

0.1500
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0.0000
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B
e
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a
14

Exhibit9:FactorBasedModel:DriversofPrivateRealEstateVariation

The results from the residual factor model present a somewhat different story. As with the factor
based model, the equity market beta is statistically significant at the beginning of the period;
however, in the global financial crisis phase, it is the bond market beta that becomes significant,
with a negative sign and there is some evidence of an influence of small cap stocks on real estate
variability that was not clearly present in the factorbased model. The growing influence of bond
market returns coincides with the sharp fall in Government bond yields illustrated in Exhibit 3.
Exhibit 10 shows the changing proportion of real estate variation explained by the residual factors
overtheanalysisperiod.

0.00%
5.00%
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30.00%
35.00%
%

o
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SmallCap Bond Equity
15

Exhibit10:ResidualBasedModel:DriversofPrivateRealEstateVariation

To provide a point of comparison, Exhibit 11 shows the factor influences on the variability of
property company returns as measured by the EPRAUK index, using the factorbased model over
thesame60monthrollingwindow,butincludingtherealestatefactor.Itisclearthatoverallequity
market returns play a significant role in explaining movement property company returns, at times
explaining over 90% of the variation. That influence though, is again timevarying, falling sharply in
thedot.comandtechnologystockbubbleand,moresignificantlyforthispaper,fallingbackinthe
global financial crisis period. In the window ending December 2006, equity market variability
explains 73% of property company return variability. For the window ending December 2008, the
proportion of variation explained has fallen to 37%. At the same time, the contemporaneous
influence of the real estate factor becomes stronger, peaking at around 19% in mid2008. It seems
that public and private real estate are behaving in a more similar manner in the financial crisis and
propertymarketcorrectionthantheywereintheassetpricegrowthphase
11
.Resultsfortheresidual
approachmodelareverysimilarwith,ifanything,therealestatefactorstillmoreprominentinthe
globalfinancialcrisisphase.

11
Onepossibleexplanationisthat,astransactionvolumesintheprivatemarketslowed,soUKvaluerswere
preparedtouseevidenceofpublicmarketpricemovementstoadjusttheirappraisalsanecdotalevidence
forthisisprovidedinIPF(2009)
0.00%
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15.00%
20.00%
25.00%
%

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SmallCap Bond Equity
16

Exhibit11:FactorBasedModel:DriversofPublicRealEstateVariation

LaggingRelationshipsandtheInfluenceofEquityMarketsonPrivateRealEstate

WhiletheemphasisinthispaperisontheshortrunrelationshipbetweenUKprivaterealestateand
theothermainassetclasses,thissectionbrieflyconsidersthetransmissionofpricesignalsfromthe
equitymarketintotherealestatemarket.First,Grangercausalitytestsareusedtodeterminelead
lagrelationshipsbetweenrealestateandthefinancialassets,giventheevidenceoflagstructuresin
the factor models. Second, a simple VAR model is run and impulseresponse analysis is used to
explorehowequitymarketsignalsaretransmittedtorealestatemarkets.

Exhibit 12 sets out Granger causality tests for both private real estate (the desmoothed IPD series)
andpublicrealestate(theEPRAUKreturns)forthewholeanalysisperiod.Theresultsarenothighly
sensitive to lag structure: we report results with four lags. The tests show that, even after
desmoothing,theequity marketand thesmall cap indexlead theprivaterealestatereturns.Asin
priorresearch,thepublicrealestateindexleadsthedesmoothedprivaterealestatereturns.Inpart,
this reflects differences in the nature of the two indices, despite having corrected for appraisal
effects.Inpart,though,itmayalsoreflecttheinertialeffectofcontractualrentalincomeinthetotal
return figure (which would lead to autocorrelation in true returns). The equity and small cap stock
indices also Granger cause the public real estate returns, emphasising this point. The sample size
when restricting the analysis to the 20072011 period is too short for stable, robust results.
However, we note that there is no longer evidence of a leadlag relationship between public and
privaterealestate(consistentwiththeresultsfromthedecompositionofpublicrealestatereturns,
above)andthereissomeevidenceofbondreturnsleadingpublicrealestate.

0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
70.0%
80.0%
90.0%
100.0%
%

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Equity Bond RealEstate
17

Exhibit12:GrangerCausalityTests:RealEstateandFinancialAssets19902011
PrivateRealEstate(IPD) PublicRealEstate(EPRA)
NullHypothesis FStatistic Prob FStatistic Prob
EquitydoesnotGrangerCauseRealEstate 3.115** 0.016 2.482** 0.044
RealEstatedoesnotGrangerCauseEquity 1.352 0.251 0.541 0.706

SmallCapsdonotGrangerCauseRealEstate 4.067*** 0.003 2.290* 0.060
RealEstatedoesnotGrangerCauseSmallCaps 1.178 0.321 0.905 0.461

BondsdonotGrangerCauseRealEstate 2.389* 0.052 3.224** 0.013
RealEstatedoesnotGrangerCauseBonds 2.576** 0.038 3.155** 0.015

PublicRealEstatedoesnotGrangerCause
PrivateRealEstate
4.373*** 0.002
PrivateRealEstatedoesnotGrangerCause
PublicRealEstate
1.812 0.127
TableshowsFstatisticsandprobabilityunderthenullhypothesisforGrangercausalitytestswithfourlags
betweenrealestateandfinancialassets,usingmonthlyreturnsJan1990Dec2011.Asterisksindicate
significanceofFstatistic:*=10%level,**=5%level,***=1%levelandbeyond.

We turn now to the VAR analysis. We ran a variety of models, having tested the variables for
stationarityanddistributionalqualities:stationaritytestsusingbothPhillipsPerronandAugmented
DickeyFullertestsrejectaunitrootinthedifferenced(returns)seriesforallvariables;alltheindex
number series however, fail to reject the null hypothesis of a unit root. We can assume that the
index numberseriesareI(1)andthereturnseriesareI(0).Wereporttheresultsofanunrestricted
VAR
12
; our focus is on impulseresponse analysis. The analysis examines the impact of a one
standarddeviationshockonthereturnsofoneofthevariablesintheVARsystemonthereturnsof
the other variables. Are there spillover impacts and, if so, how large and persistent are they? We
focusonthedirectrealestatemarketproxiedbythedesmoothedIPDreturnandontheimpactson
thepropertycompanyreturnsproxiedbytheEPRA,publicrealestate,returnseries.

Examining, first, the responses of the public real estate series to shocks in the system, Exhibits 13
and14showtheresponsetostandardisedonestandarddeviationshocksin,respectively,thepublic
real estate series(EPRA) itself and the FTAS all equity return series, with the 95% confidence band
plottedaroundtheresponseline).ReturnshockstoEPRAdonotpersistbeyondamonth;however,
thereissomeevidencethattheresponsetoshocksinthewiderequitymarketaremorepersistent,
remainingsignificantlyabovezerofortwomonthswithanechooccurringatmonthfive(theechois
presentinFTASsresponsetoFTASshocks,butitislesspronounced).

12
FulltechnicaldetailsoftheunrestrictedVARareavailablefromtheauthors.Weassumesymmetricshocks,
althoughrecognisethattheremaybeasymmetriceffectspresent.
18

Exhibit13PublicRealEstateResponsetoInternalShock

Exhibit14:PublicRealEstateResponsetoEquityMarketShock

Theresponseofthedesmoothedprivaterealestatereturnstopropertymarketshocks(whetherin
the public or private real estate markets) appears to be persistent (Exhibits 15 and 16). This is not
unexpected: the desmoothing process has not completely removed the serial correlation in the
series.Asnotedabove,thecontractualnatureofleasecontractsmeansthatincomereturnswillnot
varygreatlyfromperiodtoperiod.Thesameeffectispresentintheincome(coupon)returnsfrom
bonds. This stickiness may well contribute to the pattern of response to shocks observed in the
EPRA,propertycompanyseries,althoughitisimportant tonote theverticalscaleofthe graphand
themutednatureoftheresponse.

Finally, Exhibit 17 shows the private real estate markets response to equity market shocks. Once
again, there is evidence of stickiness in the response, although the extent of the movement is
relatively small. Even with an exacting two standard error confidence band, the response remains
statistically significant four months out, with the response still positive and at the margin of
significance after ten periods. We emphasise that the response is not large consistent with the
factor models described above and our other analyses, it seems that private real estate has a
(somewhat lagged) response to equity market movements, but a response that is masked by
valuationeffectsandthestickinessthatresultsfromthebondlikeincomereturnsoftheassetclass.

2.00%
1.00%
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6.00%
1 2 3 4 5 6 7 8 9 10
LaginMonths
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LaginMonths
19

Exhibit15:PrivateRealEstateResponsetoPrivatePropertyMarketShocks

Exhibit16:PrivateRealEstateResponsetoPublicRealEstateMarketShocks

Exhibit17:PrivateRealEstateMarketResponsetoEquityMarketShock

0.50%
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1 2 3 4 5 6 7 8 9 10
LaginMonths
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LaginMonths
20

TheVARmodelsextendourunderstandingoftherelationshipbetweenrealestatereturnsandother
asset classes, and between public and private real estate. The Granger models suggest that the
returnsintheoverallequitymarketleadpropertycompanyreturnswhich,inturn,leadprivatereal
estate returns, despite correction of valuation effects via desmoothing. There appear to be more
complex twoway relationships between bond and property returns, perhaps mediated by interest
rate effects. With a longer, six month, lag structure, there is some evidence of switching behaviour
between the equity market and private real estate (with no comparable switching behaviour
manifest between general equities and property companies). The VAR impulseresponse analyses
pointtoapersistentimpactofshocksintheequitymarketonrealestatereturnsanimpactthatis
much more pronounced for public real estate than for private real estate. In combination, these
resultspointtolongruninfluencesthatrunfromequityreturnstopropertyreturns,themagnitude
varying sharply between public and private markets. Stock market shocks (which, given the
skewness shown in Exhibit 2, are more likely to be negative than positive) are transmitted into the
real estate market, with a sharp and rapid effect on property company returns and a smaller but
moreprotractedandpersistentimpactonprivaterealestate.

Discussion

In this paper, we explored the extent to which the relationship between real estate returns and
otherassetclassesvariesovertime.Specifically,thepaperaddressedthreebroadquestions:

(a) Do the correlations between real estate returns (in particular, private real estate returns)
andthoseofotherassetclassesvaryovertime?
(b) How significant is the influence of the other financial asset classes on the volatility of real
estatereturnsanddoesthatinfluencevaryovertime?
(c) Aretherelongrunlinkagesbetweenpropertyandotherassetclassesthatleadtoshocksin
onemarketbeingtransmittedtoanother?

To an extent, all three questions address the same issue: to what extent do the apparent
diversificationbenefitsofholdingrealestateinamixedassetportfoliopersistoverthemarketcycle
and over different economic environments? Do investors get diversification when they need it and
do investors need to adjust their risk management strategies to account for any time variation in
thosediversificationbenefits?

Theresultsclearlyshowthatpropertyscorrelationswithotherassetclassesvarymarkedlyoverthe
analysisperiod,forboth publicandprivaterealestate.Publicrealestateis morecloselycorrelated
with the equity market than is private real estate, although the correlation between public and
private real estate returns has been trending upwards over the analysis period. Nonetheless, there
appear to be periods where the overall equity market and property company returns appear to be
less closely related, and periods when the equity and bond markets appear to have a stronger
influence on the direct, private real estate market. In particular, there seems to be an association
betweenpoorperformanceinthestockmarketandanincreaseincorrelationbetweenequitiesand
realestate.Thismightindicatethatdiversificationdiminisheswhenitwouldbemostbeneficial.

Examiningthedecompositionofrealestatevarianceusingfactormodels,themoststrikingresultis
thehighproportionofvariationinprivaterealestatemarkets thatcannot be explainedin termsof
variation in the equity, small cap and bond factors which could suggest that, at least in terms of
meanvariance,privaterealestatedoesoffersubstantialdiversificationbenefits,assuggestedinthe
conventional riskreturn models. There are, once again, periods in the market where the financial
21

assets seem to be more closely influencing private property returns, periods generally linked to
equitymarketpoorperformance:theearly2000sandtheglobalfinancialcrisisera.

By contrast to private real estate, influences from other asset classes on public real estate returns
are much stronger (particularly from the overall equity market, as might be expected) but also
complex in terms of variation. Intriguingly, for the periods that include the earlier phases of the
global financial crisis, the influence of the equity market seems to fall (and the influence of the
underlying private real estate market appears to strengthen). While the diversification potential of
public property companies does seem less than for private real estate (at least as captured in the
index),thereremainssufficientunexplainedvariationtosuggestthattherewouldberiskreduction
benefits.

The longrun analyses point to lags in the relationship between direct real estate returns and the
publicmarketindices:wecannotdistinguishbetweendataconstructioneffectsandmorestructural
leadlagresults.Stockmarketshocks(which,giventhedistributionofequityreturnsaremorelikely
tobenegativeshocks)areclearlytransmittedintobothpublicandprivaterealestatemarkets.The
impactonpublicpropertyissharpandcomparativelyrapid;theimpactonprivaterealestateisless
markedandmoreextended.Again,itishardtosaywhetherthisreflectsfundamentalfeaturesinthe
private market such as illiquidity and thin trading or is a function of lags in valuations processing
relevantmarketinformation.

Combining these insights, the evidence presented here confirms that both private and public real
estateofferdiversificationbenefitsin themixedassetportfoliocontext.Bothareinfluencedbythe
performanceoffinancialassets,butretainindependence.Privaterealestateseemstooffergreater
diversificationpotential,butthishastobesetagainstconcernsovertherobustnessofdataandthe
practical issues and obstacles associated with investment in the direct market. What is clear,
however, is that adopting a single time period, meanvariance optimisation approach does not
capturethechangingriskreturncharacteristicsofproperty.Betasaretimevarying;correlationsare
timevarying;theinfluenceofotherassetsonrealestatevolatilityistimevarying.Thereareperiods
inthemarketwhenthebehaviouroftheequitymarketisstronglylinkedtothatofrealestate,and
thoseperiodstendtobewhenthestockmarketisperformingbadly.Shocksnegativeshocksin
equity returns are transmitted to real estate returns and have a significant effect. A risk
managementstrategyneedstoaccountforthesetimevaryinginfluences.

There is one further implication of the results. The focus here has largely been on riskreturn
features of the assets, on mean, standard deviation and covariance. Within that, however, there is
evidencethattherelationshipbetweenassetclassesdependsonthereturnsinthoseassetclasses:
inparticular,thattheremaybestrongercorrelationsbetweenassets,betweenpropertyandequity,
when both are underperforming. This has further significance given the distribution of returns in
propertymarketsand,toalesserextent,inequitymarkets:negativeskewnessandpositivekurtosis
indicating a higher probability than normal of there being poor returns (with the serial correlation
evidentinprivaterealestatesuggestingthatthosepoorreturnsmaypersist).Thatsuggeststhat,for
a more complete view of the riskreturn characteristics of real estate we need to consider the
relationship between assets at the extremes of their return distributions to seek to identify any
taildependence.

22

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