Quick Guide to Real Estate Correlation

Believe it or not, real estate correlation is an important topic. And you should pay attention to it if you want to understand diversification. We all know that diversification is good advice. It’s right up there with some of these pieces of advice.

Listen more than you speak.
Your word is your bond.
Trust your gut
Treat people like you want to be treated

As for financial advice, you’ve probably heard things like…

Live on less than you make
Invest for the future
Diversify your portfolio

Some of this advice may sound cliche, but ultimately, it’s solid advice. In the financial world, there is tons of discussion on the subject of diversification. But how do you diversify your portfolio to optimize your results?

To answer that question, you need to understand real estate correlation.

What is the Correlation in Real Estate Investing

Correlation is a statistical measurement of the degree to which two financial assets move about one another. Diversification is not owning multiple highly correlated assets. If all those assets move in tandem, you’re not diversified. Instead, looking for asset classes with low correlation would be best.

Correlation vs. Causation

As crucial as correlation is, it’s important not to confuse it with causation. Correlation does not imply causation; that’s basic Econ 101.

Just because a statistical relationship exists between the movement of two securities doesn’t mean that one is causing the other’s movement.

Correlation Can Be Positive or Negative with Real Estate Assets

Correlation can be positive, negative, or zero. A positive correlation means that the returns of two investments tend to move in the same direction. A negative correlation means that the returns of two investments tend to move in opposite directions. A zero correlation means that the returns of two investments are independent and do not move about each other.

Real estate correlation is measured on a scale of +1 to -1; the numbers on this scale are referred to as correlation coefficients. The definitions of strong, moderate, and weak correlation can be debated, but as a general guide, the correlation coefficients can be interpreted as follows:

+1.00 Perfect positive correlation

+0.99 – +0.85 Powerful positive correlation

+0.84 – +0.70 Strong positive correlation

+0.69 – +0.40 Moderate positive correlation

+0.39 – +0.10 Weak positive correlation

+0.09 – +0.01 Negligible positive correlation

0.00 No relationship between two variables (uncorrelated)

-0.01 – -0.09 Negligible negative correlation

-0.10 – -0.39 Weak negative correlation

-0.40 – -0.69 Moderate negative correlation

-0.70 – -0.84 Strong negative correlation

-0.85 – -0.99 Powerful negative correlation

-1.00 Perfect negative correlation

Perfect positive correlation +1.00 is the strongest correlation and means that two securities move together, producing identical results. A perfect negative correlation means two securities move identically opposite, subtracting each other. A 0.00 correlation coefficient indicates that two securities move entirely independently and would be non-correlated assets.

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How Can I Avoid Negative Correlations when Investing?

Some investors mistakenly believe they must avoid negative correlations, but that isn’t true. All negative correlation means is that a security has an inverse relationship with another security. In other words, when one goes up, the other goes down, and vice versa.

This is an integral part of diversification. You want some assets going up when others are going down. It blunts the impact of the negative performing assets. It’s one reason many financial advisors recommend carrying stocks and bonds (among other things) in a portfolio. Stocks and bonds tend to have an inverse relationship.

You want to be careful about your assets canceling each other out. Therefore, some people avoid perfectly positive and perfectly negative correlated assets. Some investors also prefer to prevent strongly correlated assets, sticking with assets with correlation coefficients ranging from weakly positive to weakly negative.

Importance of Portfolio Diversification

Nobody would need to diversify if the stock market only went up. Unfortunately, it goes up and down. If you need to be reminded of this, simply look to 2022, when the S&P 500 was down 18.11%.

That’s why portfolio diversification is an important risk mitigation strategy and a core idea within modern portfolio theory. After all, a portfolio of assets from different asset classes is less risky than a portfolio of similar assets.

Reducing Correlation Risks through Diverse Investments

As the saying goes, “Don’t put all your eggs in one basket.” Diversification does matter, and that’s why so many accredited investors include the big three investments—stocks, bonds, and real estate—in their portfolios.

Countless alternative investments may also make sense to some investors. However, over-diversification can lead to dilution. Taking significant positions in assets with consistently low returns can dilute overall returns.

Over the last two decades, fewer people have purchased bonds due to their poor returns. During this time, more and more individual investors and institutional investors have started gravitating toward real estate for better returns, low volatility, and diversification.

How Real Estate Correlates to Other Investment Assets

Since real estate is one of the top three investments, let’s explore real estate’s correlation to various asset classes. To do that, we’ll utilize the National Council of Real Estate Investment Fiduciaries (NCREIF) as our benchmark for comparison.

Stocks

As you can see from the graphic above, from 2000 through 2020, private real estate has a correlation coefficient of 0.14 when compared to the U.S. stock market. This means that it has a weak positive correlation that borders on a negligible correlation. Therefore, real estate has a long track record of being an excellent investment for diversification from the stock market.

Bonds

In comparison to U.S. bonds, over the last twenty years, private real estate has a correlation coefficient of -0.12. That means that private real estate has a nearly negligible negative correlation to the U.S. bond market. Therefore it’s also an excellent diversification asset class from bonds.

Real Estate Investment Trusts (REITs)

This one often confuses people, as they believe that adding REITs to their portfolio provides a diversification benefit when it usually doesn’t.

They make that mistake because they believe they are investing in real estate when they invest in REITs. But in actuality, a REIT is a stock-based asset. So, instead, they are still investing in the stock market. Yes, they are investing in the real estate sector within the broader market, but a REIT is still a stock market-based asset.

As a stack market-based asset, it has a moderate to high positive correlation with the stock market. Therefore, its utility as a diversification tool against the stock market is limited.

Over the last twenty years, U.S. REITs are much more closely correlated with the stock market, at 0.68, than they are with private real estate, at 0.25.

Residential Real Estate vs. Commercial Real Estate

Commercial and residential real estate are different properties with different characteristics and drivers. There may be a strong correlation between residential and commercial real estate in some areas, as businesses and residents are attracted to the exact location. The two may be largely uncorrelated in other places, as the demand drivers for each property type are different.

As such, their correlations can vary based on several factors. Commercial real estate tends to be more closely tied to economic cycles and business trends, while residential real estate is more closely tied to demographic trends and can be more sensitive to local housing market changes or interest rates. With that in mind, multifamily real estate blends the best of residential and commercial real estate with less volatility than individually.

How Real Estate Correlates with Broader Economic Indicators

Multifamily real estate has a long history as a hedge against inflation and a track record for performing well during recessions. So, let’s dive into real estate correlation and its relationship with these economic indicators.

Inflation

Inflation has been a major topic in the news for over a year, as Americans have experienced the worst inflation in over forty years. Commercial real estate has a long, consistent track record for beating inflation.

NPI has exceeded CPI in 37 of the last 43 years. In contrast, the S&P 500 has only exceeded CPI in 29 of those 43 years. And rent growth for apartments also has a long history of exceeding inflation.

Image Source: Nuveen

So clearly, real estate correlation is strong with the Consumer Price Index (CPI) in inflationary times. We can quantify that positive correlation by looking at correlation coefficients. Below is a graph that compares the correlation between CPI and stocks, bonds, and real estate.

Notice that real estate has had the highest positive correlation to CPI over the last 40+ years. If you look at just the last 20+ years, you’ll see that correlation becomes stronger. Also, when inflation gets really bad, real estate also goes up significantly, while stocks are only weakly positively correlated. Bonds have a strong negative correlation in high inflation times, which is why bond investors can lose their shirts.

Recessions

I’ve written about recessions through the years. You can find that information in the following articles:

To summarize that work, the stock market is positively correlated with recessions. Over the last 100 years, every U.S. recession has had a corresponding drop in the stock market. The average decline in stock prices during a recession is -28%.

In contrast, over the last approximately 70 years, ten recessions have occurred. National multifamily apartments have remained +90% – 95% occupied during those recessions. Also, none of those recessions resulted in more than a one percent decline in occupancies.

With apartments maintaining such high occupancy levels during the recession, it should be no surprise that rent growth remained positive out of ten recessions. Apartments have performed well in good times and wrong, bull markets and bear markets.