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Property Special Report: Correlation street

Three key words for property investors are location, location, location. For investors who want to reduce the level of risk in a portfolio, three important words are diversification, diversification, diversification.

Over the past few years, commercial property has attracted substantial inflows. This is unsurprising given the returns from commercial property. In 2006, for example, IPD says the total return from UK commercial property was 18.1 per cent.

Commercial property is an important diversifier because of its low correlation to equities. This means combining property with other asset classes should reduce volatility and risk in a portfolio.

But many property funds invest in stock market-listed securities and real estate investment trusts. Surely, investing in listed securities reduces the diversification benefits of holding property?

For example, Gartmore head of multi-manager Bambos Hambi, says between January 1 and February 28 2007, the FTSE EPRA NAREIT UK index (property equities) returned -7.8 per cent compared with 1.4 per cent by the IPD UK All Property Monthly index.

He says Gartmores multimanager portfolios continue to focus on direct bricks and mortar funds because recent performance data support our contention that property shares behave more like equities than direct property holdings.

Bestinvest head of communication Justin Modray says research suggests that property securities have a 60 per cent correlation to equities whereas bricks and mortars only have a 20 per cent correlation.

But there is a group of asset managers and advisers who argue that property securities offer diversification away from equities. They argue that correlation with equities is high over the short term but over the long term securities reflect the risk return characteristics of the underlying asset class.

In May 2006, for example, global property securities returned -6 per cent, global equities returned -6 per cent, global bonds returned -1 per cent but UK property returned 1.5 per cent. However, Schroders product manager Andrew Cox says global property securities recovered in June and July 2006 while equities stabilised.

Cox says: It is the similarity of short-term returns between equities and global property securities that appears to cause doubt over the diversification benefits.

Conventional analyses of the relationship between global property securities and the wider equity markets illustrates that the correlation coefficient of monthly returns is 0.7. But Cox argues that correlation needs to be measured over the long term.

Over three years, the correlation between global property securities and general equities falls to 0.3. He says: This implies that an investor holding global property securities for two or three years will receive returns that are quite different from the wider equities market and which give meaningful diversification.

He adds that Reits reduce correlation with general equities even further. Cox says the monthly correlation between US Reits and global equities is 0.3 and falls to 0.1 over longer time periods.

Dr Shaun Bond, senior lecturer in real estate finance in the department of land economy at the University of Cambridge, and Professor John Glascock, Grosvenor professor of real estate finance in the same department, also believe research shows that property securities offer diversification benefits to investors.

They say property securities behave as a defensive asset. Bond and Glascock say property securities follow the stockmarket on soft downturns but not as strongly and have proved to be countercyclical following the major adjustment after the dotcom crash in 2000 and 2001.

During the Asian crisis in 1997 and the February 2002 to June 2003 adjustment, both stocks and property fell but property showed less of a decline. During the general market adjustment of June 2000 to October 2001, the market fell considerably but the EPRA real estate portfolio grew in value at a solid pace.

We believe this defensive nature of real estate is its key diversification driver and this arises because of attributes such as a solid cash flow of dividends. Bond and Glascock also looked at the effect of adding property securities to portfolios containing equities, bonds and cash in Belgium, France, Italy, Netherlands, Spain, Sweden, Switzerland and the UK.

They say: For every country, as more real estate is added to the portfolio, the average return of the portfolio increases. In almost all cases, the total risk (standard deviation) of the portfolio falls.

They admit that at 0.46, there is a high correlation between equities and property securities. This reflects the fact that real estate and equities are key assets in the economy and likely to be driven by similar economic factors that drive the overall equity markets.

Despite this high correlation, real estate securities do provide diversification benefits to investors. It should also be remembered that apparently low correlations reported between the stockmarket and measures of the performance of direct real estate markets are likely to be due to substantial measurement error.

Fidelity International head of IFA channel Peter Hicks says: Most directly invested retail property funds limit exposure primarily to the UK but property securities funds tend to be more diversified across the globe with an average weighting of around 30 per cent in the UK.

As the correlation of the worlds property markets is low, property securities funds benefit from greater diversification.

Another issue that investors need to consider is liquidity. Advisers argue that if investors are cautious about the medium-term outlook for commercial property, they should consider using property securities funds rather than bricks and mortar funds because they will be able to sell property securities the same day. If liquidity dries up, it can take months for funds to redeem direct property holdings.

Nevertheless, Allenbridge director Jason Day says while investors will be able to redeem from property securities, this may be at a substantial capital loss if sentiment turns against the asset class.

Investors also need to consider whether to invest in open or closed-ended funds, particularly for bricks and mortars funds.

Matrix sales and marketing manager Nick Hill says the advantage of closed-ended bricks and mortars funds is their ability to control inflows and outflows. If sentiment turns against property, open-ended funds might have to sell property holdings to meet redemptions. This may take many months.

Some open-ended bricks and mortars funds hold up to 15 per cent of their portfolios in property securities and cash to aid liquidity. Property securities are more highly correlated to equities than direct property, particularly over the short term. But research does suggest they can provide diversification benefits as well as greater liquidity.


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