The property sector is commonly said to perform between equities and bonds, which is a consequence of the dual nature of its returns: a fixed income component, namely rent; and a market-driven one, i.e. capital appreciation. It is also generally believed that these characteristics render this asset class particularly suitable for diversification purposes.
With this in mind, an investor trying to decide how to allocate his or her resources across different asset classes must answer a key question: What is the optimum level of real estate for maximising portfolio performances?
To find the answer, it is of utmost importance to understand how market trends in the property industry relate to those in the traditional asset classes, namely equities and bonds. A good way to get started is to analyse historical data.
Long-term analysis of investment classes
Chart 1 below shows the total returns of the three main investment classes over a 66-year period. (Since Real Estate Investment Trusts [REITs] were only introduced in the UK in 2007, data refer to direct investment opportunities in the property market as a whole.)
It can be deduced from the graph that, despite common beliefs, real estate has rarely performed between shares and bonds. Rather, the industry returns have quite often either been above or below the returns yielded by the other asset classes.
We can see that real estate either outperformed or lagged behind both equities and bonds during most of the second half of the 20th century. The only period when the property market consistently yielded returns between equities and bonds was during the 1950s.
Looking in more detail, it is evident that:
- Real estate returns were around 7-8% during the 50s, making them a good diversifier and portfolio optimiser;
- Returns steadily increased during the 60s owing to unprecedented performance of the real estate market, which rallied above traditional assets;
- Relative real estate returns dropped again during the mid-70s, when many investors raised their exposure to publicly traded companies;
- The downward trend in real estate returns that started in the 1980s lasted until the dot-com crash in 2001, which revealed the instability of the major stock exchanges.
Historical property risk
Real estate is still considered to be a safer, more conservative asset (when compared to speculative investments), particularly because of the fairly low volatility of returns . While capital gain is highly affected by market conditions, rent is extremely stable as a consequence of the rigid lease terms stipulated by English legislation.
Again, property risk is generally believed to sit between that of equities and bonds. When analysing the data (see Chart 2, below), there is evidence that this has been the case at various points since 1950, but we can also see that the real estate market was less volatile than government fixed income security for most of the latter part of the 20th century. This should be a key consideration for investors aiming to optimise their portfolio using the Sharpe ratio as an efficiency metric.
The real estate market being generally less volatile than bonds can be attributed to the lower fluctuations of property yields compared to bond yields. But why does this happen? The answer can be found in the response of the assets to inflation: despite being a relatively stable income, rent is not fixed and can be raised to compensate for inflationary pressure. Conversely, bond coupons cannot be changed once the security has been issued (there are some exceptions such as index-linked bonds) and the only compensation for investors comes from yield changes, which are then reflected in the price.
Correlations between asset types
Charts 3, 4 and 5 below show the correlations between real estate and the other asset classes.
There are three important conclusions that can be drawn from the charts above: first, the correlation between real estate and government bonds (Chart 5) seems to be weak and of relatively low volatility; second, the relationship between properties and equities (Chart 4) appears to be V-shaped, pivoting around 1980; third, although fixed income and shares (Chart 3) had been aligned in the past, they started moving in opposite directions from 1990-2000. It might be interesting to further investigate the trend shown by real estate and equities (Chart 4): their correlation slumped at -0.8 in the period 1978-1988, when inflation started decelerating.
Correlation and inflation
Looking at the data, it’s no surprise that the diversification potential of real estate has been debated during the last decade. While properties have progressively gained more and more correlation with stock markets, bonds have moved in the opposite direction. As a result, it seems to be more sensible for an investor to diversify an equity portfolio buying government debt, rather than buildings. What’s more, this choice is incentivised by the huge difference in acquisition costs and the eroding power of inflation.
Furthermore, the tables below confirm the trends previously identified:
- Correlation with the stock market has increased significantly during the first decade of the 21st century, possibly due to the introduction of REITs in the UK;
- Correlation with bonds fluctuated around zero and seems to be very weak now;
- Strong negative correlation with UK short-term gilts.
To conclude, there is evidence that real estate assets historically behaved differently than expected, and their risk and returns do not necessarily lie between those of equities and government bonds. Although it is difficult to determine a single optimum level of property to optimise portfolio performance at each point in time, owing to unpredictable fluctuations in the market, it is important to understand how this level varied through the years. In particular, as we will see in Part two of this article, the target percentage of property within investors’ portfolios was subject to profound changes, especially after the 1980s.
(1) Scott The Property Masters to 1970, MSCI / IPD, Barclays Capital Equity-Gilt Study
(2) Source: Scott The Property Masters to 1970, MSCI / IPD, Barclays Capital Equity-Gilt Study
(3) Source: Scott The Property Masters to 1970, MSCI / IPD, Barclays Capital Equity-Gilt Study
(4) Source: Scott The Property Masters to 1970, MSCI / IPD, Barclays Capital Equity-Gilt Study
(5) Source: Scott The Property Masters to 1970, MSCI / IPD, Barclays Capital Equity-Gilt Study
(6) Source: Scott The Property Masters to 1970, MSCI / IPD, Barclays Capital Equity-Gilt Study
__Sources (tables) __
(1) Source: Scott The Property Masters to 1970, MSCI / IPD, Barclays Capital Equity-Gilt Study
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