Time‐varying correlations between stock and direct real estate returns

Abstract

PurposeUnderstanding correlations between stock and direct real estate returns, which is the key factor that determines diversification benefits in a portfolio, helps formulate and implement better investors' asset allocation and risk management strategies. The past studies find that direct real estate returns have a low unconditionally (long‐run) correlation with the returns of equities. However, assuming that such correlation is constant throughout all periods is implausible. The purpose of this study is to test the time‐varying correlations of returns between general stocks and direct real estate.Design/methodology/approachThis study uses the dynamic conditional correlation (DCC) model, which is a simplified version of the multivariate generalised autoregressive conditional heteroskedasticity (GARCH) model, proposed by Engle to test the time‐varying correlations between stock and direct real estate returns in six markets, which include the USA, the UK, Ireland, Australia, Hong Kong and Singapore.FindingsThe empirical results show significant time‐varying effects in the conditional covariance between stock returns and direct real estate returns. The results vary across different real estate sub‐sectors, and across different countries. It is observed that the conditional covariance increases in the boom markets, but becomes weaker in the post‐crisis periods. The authors observed significant jumps in the conditional covariance between the two asset markets in Singapore and Hong Kong in the post‐1977 Asian Financial crisis periods and in the post‐2007 US Sub‐prime crisis periods.Originality/valueThe past studies find that direct real estate returns have a low unconditionally (long‐run) correlation with the returns of equities. However, assuming that such correlation is constant throughout all periods is implausible. This study fills in the gap by using the dynamic conditional correlation models to allow for time‐varying effects in the correlations between stock and real estate returns.