Believe it or not, real estate correlation is an important topic. 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 in relation to one another. Diversification does not mean owning multiple highly correlated assets. If all those assets move in tandem, you’re not diversified. Instead, it would be best to look for asset classes with low correlation.
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 in relation to 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 Very strong 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 Very strong 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 of one another, subtracting each other out. A 0.00 correlation coefficient indicates that two securities move entirely independently of one another and would be non-correlated assets.
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How Can I Avoid Negative Correlations when Investing?
Some investors mistakenly believe that they need to avoid negative correlations, but that isn’t true. A negative correlation means 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 why many financial advisors recommend carrying both 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. For that reason, some people avoid perfectly positive and perfectly negative correlated assets. Some investors also prefer to prevent strongly correlated assets from sticking with assets with correlation coefficients ranging from weakly positive to weakly negative.
Importance of Portfolio Diversification
If the stock market only went up, then nobody would need to diversify. 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 three significant 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 individual 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 at best.
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.
Image Source: Neuberger / Berman
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 strengthens. Also, when inflation gets terrible, real estate goes up significantly, while stocks are only weakly positively correlated. Bonds have a robust negative correlation with high inflation so that bond investors can lose their shirts.
Recessions
I’ve written about recessions through the years. You can find that information in the following articles:
- Recession Proof Investments
- How Multifamily Investing Can Resist a Recession
- How Would a Recession Affect Multifamily Investing
- Four of the Best Investments During a Recession
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 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 in nine of ten recessions. Apartments have performed well in good times and bad, in bull markets and in bear markets.
37th Parallel’s Leading Real Estate Investment Fund
As you can see, the evidence is clear. Real estate, particularly multifamily real estate, is an excellent diversification tool in a portfolio of stocks and bonds. It also performs well in recessionary times and is an excellent hedge against inflation.
The good news is that the average accredited investor doesn’t have to become a landlord to add real estate to their portfolio. Instead, they can partner with professionals to maximize their results.
37th Parallel Properties latest Income and Total Return Fund is an investment vehicle and something all accredited investors should consider.
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Contact Us Today for a Consultation
Do you have multifamily real estate in your portfolio? If not, maybe you didn’t previously understand real estate correlation and diversification. Now that you do, you owe it to yourself to learn more about investing in apartments.
The best way to get started is to schedule a complimentary consultation with 37th Parallel Properties. Now, see how you can optimize your investment portfolio with real estate.