Commercial property is usually regarded as important in helping diversify the volatility of returns in multi-asset portfolios, due to its weak correlation with other assets.
But the financial upheaval in 2008/09 affected virtually all asset classes. Commercial property suffered and the peak-to-trough decline of the IPD UK Monthly index between June 2007 and July 2009 of 44.2 per cent represented the worst nominal decline in capital values during the 23-year history of the index.
Correlations between asset classes are rarely stable and it is important to examine trends over time. Tracing UK property relative to UK equities shows a gradual increase and the rolling 36-month correlation has risen from 0-0.2 from late-2003 to 2005, to around 0.4 more recently (see chart). But property has become less correlated to gilts over this time and after recording broadly similar correlation to the property/equity relationship from the end of 2003-06, the returns became negatively correlated.
The IPD index is valuation-based, rather than calculated on traded prices, and the high serial correlation of returns can influence analysis. However, adjusting for serial correlation did not make any significant change to the outcome.
Why has the correlation of commercial property with UK equities risen modestly, while falling against gilts? The property market has been increasingly driven by changes in yields, as opposed to the absolute level of income or by changes in rental values. The capital market effect, rather than the impact of changing rental values or current income, seems to have become relatively more important.
Shortening lease lengths may have contributed to this effect. But perhaps the main reason has been the growing importance of retail funds as a source of capital inflows/outflows.
The 2007/09 commercial property downturn was remarkably quick. In the 1990s cycle, the peak-to-trough decline in capital values extended for 43 months. In the most recent downturn, it took just 25 months. It is likely that the speed of this capital market-led decline, and the subsequent recovery since the middle of last year, has been driven by retail funds.
So, can property continue to play a helpful diversifying role in a multi-asset portfolio? Probably, since the correlation with UK equities remains weak when compared with asset combinations, such as the 0.9 correlation between UK and global equities (see chart). The correlation of property with gilts has also reduced significantly and the inclusion of non-UK property can further assist diversification.
Guy Morrell is head of multimanager at HSBC Global Asset Management