Portfolio Diversification

One of the key concerns for any sophisticated or institutional investor, especially those who subscribe to Modern Portfolio Theory, is portfolio diversification in order to maximise returns while operating at certain levels of acceptable risk.

One of the key factors described by Markowitz in Modern Portfolio Theory is ‘correlation’: the extent to which two assets move in relation to each other. Positive correlation means that the assets move in the same direction (the higher the number, the more correlated the assets are). Negative correlation means that the assets move in opposite directions.

When evaluating potential investment opportunities, investors should consider whether an investment is correlated with their existing investments, and whether the investment would actually provide the diversification benefits they seek.

Correlation between Australian Equities & Australian Real Estate

The correlation between Australian real estate and the equities market was analyzed by Heaney and Sriananthakumar in their paper Time-varying correlation between stock market returns and real estate returns, published in the Journal of Empirical Finance in 2012.

Their paper found that investment in commercial or residential real estate provided considerable diversification benefits for those invested in Australian equities. However, they did note that correlation between commercial real estate and shares increased during the Global Financial Crisis, indicating that it offers less diversification benefits in times of business strife.

However, the exact equities owned does affect the level of correlation: more than 35 percent of the S&P/ASX 200 is made up of banks and other financial firms, and approximately 60 percent of the banks’ assets are in residential mortgages. Naturally, investments in companies who derive their wealth directly from the property market will have a high level of correlation with the property market.

They also found that conditional correlations between the equities market and A-REITS was quite high, suggesting that A-REITS behave more like shares than real estate assets.

Correlation Between Global Real Estate & Australian Real Estate

Real estate is fundamentally a localised asset class, as it is driven by local demographic trends and economic factors. The lack of synchronisation across global economic cycles means that investing in property beyond one’s domestic market generally offers significant diversification benefits.

In 2017, Invesco Real Estate evaluated data from the National Council of Real Estate Investment Fiduciaries and MSCI Investment Property Databank and found that Australian real estate has the following levels of correlation with other real estate markets:

Of note is the particularly low levels of correlation between the Australian residential property market and those in China and Hong Kong, at 0.07 and 0.27 respectively, indicating that Australia should be of interest for investors in those regions interested in portfolio diversification.

In summary, the data available indicates that Australian Real Estate is a low-correlation alternative asset classe that provides diversification benefits for investors who already have stakes in global real estate and Australian equities.