Conditional Correlations and Real Estate Investment Trusts

While REITs are often presented as useful tools for diversification, little is known of the way their returns correlate with the returns of other asset classes over time and in periods of high volatility. This paper addresses this issue and draws two conclusions. First, the correlations between REITs and equity returns rose over the period analyzed, while the correlations with bonds and commodities fell. This indicates to equity portfolio managers that real estate has lost some of its diversification properties, but to bond and commodity portfolio managers it has become attractive for strategic asset allocation. Second, the correlations with REITs rose especially in periods of above average volatility in equity and bond markets. This is unfortunate as it is precisely in periods of high volatility that investors need the benefits of diversification the most. There are, however, two noticeable exceptions (for the US government securities and the GSCI), where the conditional correlations with REITs fell in periods of high volatility in these markets. This indicates that to reduce the total risk of their portfolio investors in US government securities and commodities should tilt their asset allocation more towards real estate when they anticipate changes in monetary policy or abnormal fluctuations in commodity prices.