The Changing Benefit of REITs to the Mixed-Asset Portfolio
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The Changing Benefit of REITs to the
Mixed-Asset Portfolio
Stephen L. Lee
Cass Business School,
City University London,
106 Bunhill Row,
London,
EC1Y 8TZ,
England
Phone: +44 20 7040 5257, E-mail: Stephen.Lee.1@city.ac.uk
Abstract
A number of studies have examined the allocation of public real estate securities (REITs)
in the mixed-asset portfolio. Yet no study has explicitly examined what are the benefits
REITs offer to the traditional capital market only mixed-asset portfolio, i.e. whether
REITs are a return enhancer, diversifier, or both? This paper examines this issue using
the method suggested by Liang and McIntosh (1999), which decomposes the overall risk-
adjusted benefits of an investment to an existing portfolio into its diversification benefits
and return benefits. The results show that REITs offer different benefits to different asset
classes and the mixed-asset portfolio and that these benefits have changed over time.
Thus, whether REITs can have a place in any future mixed-asset portfolio largely depends
on the relative return performance of REITs versus the alternative asset classes within the
mixed-asset portfolio.
Keywords: REITs, Mixed-asset portfolios, Diversification Benefits, Returns BenefitsThe Changing Benefit of REITs to the Mixed-Asset Portfolio
Introduction
Investment in private real estate offers considerable advantages: it is a tangible asset with
low volatility; and it generates an attractive income stream and long-term capital
appreciation and particularly strong diversification benefits to stocks and bonds. Thus,
there is extant literature showing that private real estate has a significant place in the US
mixed-asset portfolio: see, Fogler (1984); Webb, et al. (1988); Ennis and Burisk (1991);
Gilberto (1992); Fisher, and Sirmans (1994); Coleman, et al. (1994); Kalberg, et al.
(1996); Ziobrowski and Ziobrowski (1997); and Firstenberg, et al. (1998); among others.
Private real estate however has considerable drawbacks too – it is illiquid, needs expert
management and is “lumpy”, requiring significant capital to build a diversified portfolio.
Private investment in real estate therefore is only realistic for investors with hundreds of
millions to invest. Consequently, investors have sought alternatives, such as publicly
traded real estate securities (REITs) to invest in so as to gain the advantages of private
real estate investment without its disadvantages. Thus, many institutional investors and
long term investors take large positions in more liquid REITs, as compared to privately
held real estate equities (Ciochetti, et al., 2002). There is considerable debate however as
to whether REITs are real estate, stocks or bonds, or a combination of all three.
McMahan (1994) argues that because REIT cash-flows are derived from real estate the
performance of REITs should be influenced by factors affecting the physical assets, such
as general demand/supply changes due to such items as rents and demographic changes.
REIT index returns, however have not behaved in the same way as the private real estate
for at least two reasons. First, for a long time the index that measured the performance of
REITs, the National Association of Real Estate Investment Trusts (NAREIT) Index,
consisted largely of retail, multifamily and healthcare properties, while the index that
measured the performance of private real estate, the National Council for Real Estate
Investment Fiduciaries (NCREIF) Index, was mainly composed of office, industrial, and
retail properties (Mueller and Mueller, 2003).
Second, as financial securities, REITs follow a different return generating process than the
underlying real estate market. Since, REIT is an ownership and operating construct
wrapped around the properties that might otherwise be privately owned (Peyton et al.,
2007). As such the REIT structure brings with it pricing mechanisms, liquidity features
and leverage characteristics that are different from privately owned real estate. These
features, in turn, contribute to the differences in the respective risk/return profiles of
REITs and privately owned real estate (Connor and Falzon, 2006). For instance, Pagliari,
et al. (2005) estimate that U.S. REITs had an average debt-to-value ratio of around 40%
in the period 1981-2001 (with the average rising to 50% towards the end of their analysis
period). Since, financial leverage increases the interest rate sensitivity of REIT returns
(Allen, et al, 2000) REITs should be more affected by interest rate changes than the
private real estate market. Indeed, Swanson, et al. (2002) and Allen, et al. (2000) both
find that real estate returns are sensitive to both short and long-term interest rate changes.
Page 1Karolyi and Sanders (1998) find that both a stock and a bond return premiums are priced
in the return to REITs. Cheong et al. (2006) find that REITs have a long-run co-
integrative relationship with both the stock market and long-run interest rates. A
conclusion supported by Ling and Naranjo (1997, 1998) who identify growth in
consumption, real interest rates, the term structure of interest rates and unexpected inflation
as systematic determinants of real estate returns, which are the same state variables that
affect all assets classes. Sanders (1996, 1998) reports that REITs are more influenced by
the market risk premia on high-yield corporate bond index rather than government bonds.
While, Chan, et al. (1990) found that long-term U.S. Treasury bond and the high-yield
corporate bonds are important macroeconomic variables in explaining the returns of
EREITs. By way of a contrast, Liang, et al. (1995) found that EREIT price changes are
insignificantly affected by interest-rate movements. In addition, Hemel, et al. (1995)
showed that REITs have a lower correlation with interest rates than the S&P500 index
has with interest rates, which casts doubts on the argument that REITs behave more
closely with bonds than with stocks. Nonetheless, Allen, et al. (2000) show interest rate
changes are still important in determining REIT prices. In addition, using multifactor
asset pricing models a number of authors all report that the REIT market is integrated
with the general stock market (see, Ambrose, et al., 1992; Liu and Mei, 1992; Mei and
Lee, 1994; Li and Wang, 1995; and Lee and Chiang, 2004). By way of contrast, Wilson
and Okunev (1996); Wilson, et al. (1998) and Nelling and Gyourko (1998) find no
significant evidence to support the co-integration of REITs and the stock market either
domestically or internationally. These contradictory results may be because recent
research suggests that REITs behave more like value stocks, especially small cap value
stocks, rather than growth stocks, due to the high income component in REIT returns.
For instance, Clayton and Mackinnon (2001 and 2003) find that over the period 1978 to
1998 there was a switch in the major factors associated with REIT returns from large
stocks to small stocks. A conclusion supported by Mueller et al. (1994); Liang and
McIntosh (1998); Sanders (1998); Ziering, et al. (1997); Stevenson (2001); and Chiang
and Lee (2002) among others, who all show that the performance of REITs can be largely
explained by the performance of small cap value stocks rather than common stocks in
general and growth stocks in particular.
Since, 1993 however there have been a number of institutional changes in the REIT
industry that suggest that REITs now behave more like private real estate. First, Mueller
and Muller (2003) note that since 1997 the composition of REIT portfolios has become
more like that of the private market. Second, as the result of the tax changes in the
Revenue Reconciliation Act of 1993 and the REIT Modernization Act of 1999 large-scale
investments in REITs became more desirable to institutional investors (Cannon and Vogt,
1995 and Fickes, 2006). For instance, Swanson, et al. (2002) find that after 1993 REITs
became less sensitive to interest rate movements than before 1993. Glascock and Ghosh
(2000) and Glascock, et al. (2000) find that REITs behaved more like fixed-income
government bonds prior to 1992 but more like stocks after 1992, due to the increased
institutional ownership and sheer increases in size. As such the correlation between the
public and private real estate investment markets has increased (see Acton and Poutasse,
1997; and Ziering, et al., 1997 among others). Additionally, Karolyi and Sanders (1998)
established that there is a significant idiosyncratic component in REIT returns, which is not
Page 2captured by stocks and bonds, implying that REIT returns may also be reflecting the
performance of their underlying real estate. A conclusion supported by Sanders (1998)
who finds that the while the Wilshire Small Value index and the high-yield corporate
bond index have had the greatest power in explaining EREIT returns there is still a
considerable amount of unexplained variation in REIT returns that cannot be diversified
away with major stock and bond indices, particularly since 1991. In other words, in the
long-run REIT returns tend to behave more like private real estate than stocks, even
allowing for the presence of a large stock market component (Pagliari, et al., 2005).
At the same time the sensitivity of REIT returns to the stock market showed a significant
decrease in the 1990s. Ghosh, et al. (1996) reports that REITs look less and less like
stocks over time. Clayton and Mackinnon (2001 and 2003) find that REITs gradually
began to reflect the nature of the underlying, unsecuritized assets and become less
dependent on market stock indices. Studies such as Chandrashekaran (1999) and
Conover et al (2002) have also reported similar findings. However, more recent evidence
finds that the declining trend observed in the nineties has reversed since the start of the
new millennium. Cotter and Stevenson (2006) use a multivariate GARCH model to
analyse the dynamics in REIT volatility and find an increasing relationship between
ERIETs and stock market returns over the period from 1999 to 2003. Chong et al (2009)
and Case et al (2010) using similar methodology but a longer data period report similar
results.
In summary, the results of past research indicate that REITs show the characteristics of
small cap value stocks and so will perform relatively badly when growth stocks perform
well and visa versa. Second, due to their use of leverage REITs are likely to be more
sensitive to interest rate changes than private real estate and will perform badly in times
of financial distress than private real estate and visa versa. Lastly, in the long-run REITs
tend to behave more like private real estate than stocks, even allowing for the presence of
a large stock market component and this effect has increased since 1993. Hence, REITs
will perform badly when private real estate performs badly and visa versa.It is not
surprising therefore to see that the contradictory results as to whether REITs have a
place in the mixed-asset portfolio arises primarily from differences in time periods
considered as the legal and regulatory infrastructure of the REIT industry has changed a
great deal over time (see, Corgel, et al. 1995 and Zietz, et al. 2003).
Kuhle (1978) examined the effect of including EREITs into a portfolio of common stocks
using monthly data for the period 1980 to 1985 and concludes that REITs do not add
significant increases in Sharpe performance. Gyourko and Nelling (1996) and Paladino
and Mayo (1998) coming to similar conclusions. Hudson-Wilson (2001) shows that
REITs underperformed both bonds and stocks on a risk/return basis over the period from
1987 to 2000. Mueller, et al. (1994) shows that EREITs were only a valuable addition to
the mixed-asset portfolio for the 1976-1980 and 1990-1993 time periods but not for the
1980-1990 sub-period due to the high positive correlation that EREITs show with small-
cap stocks and the S&P 500 index, but weak positive correlation with bonds. In contrast,
Ibbotson Associates, on behalf of NAREIT (NAREIT, 2002) found that the inclusion of
REITs into a well-diversified stock and bond portfolio could have enhanced returns by up
Page 3to 0.8% annually over the period from 1972 to 2001 and by 1.3% annually for the years
1992-2001. Lastly, Lee and Stevenson (2005) find that REITs consistently provide
diversification benefits to the mixed-asset portfolio and that these benefits tend to
increase as the investment horizon is extended. Nonetheless, none of the previous studies
examined the magnitude and the type of benefits REITs offer the mixed-asset portfolio.
In other words, is real estate a return enhancer, diversifier or both? This, study examines
this issue using the method suggested by Liang and McIntosh (1999), which decomposes
the overall risk-adjusted benefits of an investment to an existing portfolio into its
diversification benefits and return benefits.
This study contributes to the current literature in two significant ways. First, it is the first
study to explicitly analyzing what benefits public real estate offer the US mixed-asset
portfolio. Second, rather than simple analyzing the benefits of public real estate over the
entire time period under investigation we examine the evolving behaviour of the benefits
of REITs to the capital-market mixed-asset portfolio by breaking the data down it a
number of sub-periods and performing a rolling analysis as pervious studies indicated
that the REIT return data exhibits a number of structural breaks as a consequence of
changes in the legislation governing the REIT industry (see, Clayton and Mackinnon,
2001, 2003; and Lee et al., 2008).
The paper is set out as follows. The next section provides a brief history of REITs in the
US. Section three outlines the approach of Liang and McIntosh (1999) of how to
decompose the overall risk-adjusted benefits of an investment to an existing portfolio into
its diversification benefits and return benefits. The next section discusses the data and the
benefits of REITs to the traditional asset classes on an individual basis. Section five
presents the results for the mixed-asset portfolios, while the last section concludes the
study.
The Evolution of REITs
The US Congress introduced the REIT structure under the Real Estate Investment Trust
Act of 1960 to make investments in large-scale, income producing real estate accessible
to smaller investors (Fickes, 2006 and Block, 2002). The Congress decided that the way
for average investors to invest in large-scale commercial properties was the same as they
invested in other industries, through purchasing equity. Once the structure was created, it
was only a few years until the first REITs were established.
But since its inception the US REIT market has developed anything but evenly with a
number of structural shifts occurring in the industry linked to changes in the tax laws and
regulations governing REITs (see, Ghosh, et al. (1996) and Ziering, et al., 1997; among
others). For instance, during the sixties only ten REITs of any size existed, a figure that
only increased to about 50 by the mid-1970s. Furthermore, most of these REITs were
heavily involved in land, construction and construction loans. Indeed, in 1972, short term
construction and development loans constitution over 50% of all REIT assets.
Consequently, REIT returns were enormously influenced by interest rate changes at this
time. Thus, as interest rate rose in 1972 following the ‘oil price shock’ and the yield
Page 4curve inverted these REITs experienced cash flow problems leading to many of REITS
going bankrupt. So that between 1974 and 1976 total REIT assets fell from $20bn to
$9.7bn, with the average REIT only surviving 94.6 months (Glascock and Hughes, 1995).
It is not surprising therefore to see that REITs performed poorly in comparison with the
other asset classes in this period (see Chan, et al, 1990; Khoo et al., 1993; Hah and Liang,
1995; and Sanders, 1998 among others).
Following the rebound of the real estate market in the early 1980’s due to the pent up
demand from the ‘oil price recession’ REITs showed greater risk/return performance from
increasing property values due to a number of changes. First, long-term debt replaced
short-term debt with overall debt levels declining from 70% to 50%. Secondly, land
development and construction loans dramatically reduced to less than 5% of industry
assets (Ziering, et al., 1997).
The year of 1986 is a major milestone in the REITs history (Cannon and Vogt, 1995 and
Fickes, 2006). Prior to 1986, REITs were prohibited from both operating and managing
their own real estate but following the 1986 Tax Reform Act, which included the Real
Estate Investment Trust Modernization Act this restriction was removed providing REITs
with the ability to manage most types of income-producing commercial property with
greater management flexibility, under a less restrictive tax environment and changes in
the deprecation allowances (Cannon and Vogt, 1995, and Fickes, 2006). So that REITs
started to earn more income from rents leading to strong dividend growth, allowing
REITs to generate higher revenues with less risk (Howe and Jain, 2004).
Consequently, REITs gained greater popularity for institutional, corporate and individuals
investors (Gorgel, et al., 1995). However, the savings and loan crisis of the late 1980’s,
coupled with overbuilding in the commercial real estate sector and the capital shortage
problem caused by the 1989 Financial Institutions Reform Act, which reduced the ability
of banks and savings and loans to invest in real estate, led to a real estate crash by the end
of the decade, resulting in poor return performance in the REIT sector.
The early 1990s led to an even greater fundamental change in the REIT industry as a
result of the introduction of the Umbrella Partnership REIT (UPREIT) structure and the
Revenue Reconciliation Act of 1993. An UPREIT is a combination of a REIT and a Real
Estate Limited Partnership (RELP). It is viewed as an “umbrella partnership,” where the
“investors” (i.e., REIT shareholders or capital contributors) serve as a general partner
while the “sponsors” (i.e., property contributors) constitute the limited partner of the
Operating Partnership owning all the properties (see Capozza and Seguin, 2003 and Sinai
and Gyourko, 2004 for further details).
The UPREIT concept was first implemented in 1992 with the Taubman REIT IPO.
Taubman had a large debt position that was maturing. Selling off part of the portfolio to
repay the debt would have triggered significant tax liabilities. Thus, by structuring the
IPO as an umbrella partnership, Taubman was able to raise the crucial capital needed to
repay the loan without triggering capital gains. Then following the private letter rulings
from the Internal Revenue Service (IRS) approving the new UPREIT form, the majority
of REIT IPOs in the 1990s adopted the UPREIT structure with 43 REIT IPOs in 1993 and
Page 538 in 1994 (Chen and Peiser, 1999). Ling and Ryngaert (1997) document that the
average institutional holding of Equity REIT IPOs issuance increased from 10.1% during
the 1980-1988 period to 41.7% during the 1991-94 period. Additionally, in the mid-
1990s, a number of existing REITs recognised that they were at a competitive
disadvantage to the new REITs and thus converted to the UPREIT form. Further
impetuous to the UPREIT structure came with the passage of the Omnibus Budget
Reconciliation Act of 1993, whose purpose was to encourage institutional (especially
pension fund) investment in the moribund real estate sector of the economy (Downs,
1998), leading to institutional investors owning 53% of outstanding UPREIT shares by
1998 (Ciochetti et al., 2002).
The most important legislative milestone for the REITs industry is the Revenue
Reconciliation Act of 1993, which led to the dawn of the ‘New REIT Era’. Prior to 1993,
to be qualified as a REIT, more than 50% of its shares could not be owned by five or
fewer individuals. However, pension funds were treated as a single individual even if it
had many participants as such pension funds were effectively restricted from holding
REITs in any substantial quantity. For example, Wang et al (1995) report fewer
institutional investors investing in REIT stocks than in the general stock market up to
1992. The 1993 Revenue Reconciliation Act changed the five-or-fewer rule by allowing
an individual pension fund to be counted as individuals (Brandon, 1997; Craft, 2001 and
Fickes, 2006). Thus the interest by pension funds and other institutional investors in the
REIT market substantially increased resulting in REITs growing as a mainstream
investment option (Below, et al., 2000; Crain, et al., 2000 and Fickes, 2006). For
instance, Chan, et al. (1998) find that while institutional ownership in REITs ranged from
12% to 14% in the period of 1986 to 1992 it increased substantially to 30% by 1995.
Downs (1994) also identifies a number of changes in the economic climate, which led to
the REIT explosion of the 1990’s. First, the low interest rate at this time drove many
investors out of saving accounts towards investments with higher yields, such as REITs.
Another aspect is the collapse of commercial real estate property prices over the period
1989-1992. This drop in market prices drove yields on such properties up to 8%-13%.
This resulted in a large spread between dividend cost of funds raised through REITs and
the yields that could be earned by investing those funds in existing commercial real estate.
This created a strong incentive for people to start REITs to take advantage of this positive
funding spread.
The most recent change in the US REIT industry is the REIT Modernization Act of 1999,
which reduced the income distribution requirement for REITs from 95% to 90% of
taxable income and allowed REIT to own up to a 100% controlling stake in a taxable
REIT subsidiaries (TRS) that provide services to REIT tenants, without disqualifying the
tax exempt status of the rents that a REIT receives from its tenants. However, the Act
puts an upper limit on the TRS securities holdings of REITs which may not exceed 20%
of their total assets. Moreover, the dividends from TRS are not classified as tax-exempt
income of REITs. Howe and Jain (2004) showed that the REIT Modernization Act had a
modest positive effect on REIT shareholder wealth and they also documented a
significant decline in systematic risk. According to industry and the media reports the
Page 6REIT Modernization Act was the most significant amendment in REIT legislation as it
meant that REITs are now more like operating firms than funds, which has been
evidenced by the inclusion of a number of REITs by the S&P in its market indices from
October 2001 (Chan, et al., 2003). Consequently, the market for REITs has shown a
tremendously growth since the start of the new millennium, with the number of REITs
listed on the New York Stock Exchange in 2003 standing at 144 with a market
capitalisation of $204bn, these REITs owning more than US$400 billion of commercial
real estate.
Diversification and Return Benefits
The simplest way to examine the benefit from holding a portfolio consisting of an
allocation w in investment i and (1-w) in an existing portfolio is to calculate the
difference in returns between the old and new portfolios:
R new old R new R old
where (1)
R new w i R i (1 w i )R old
Where: Rnew is the return of the new portfolio, Rold is the return of the existing (old)
portfolio and wi is the weight in investment i.
However, because the old and new portfolios have different risk characteristics the two
portfolios cannot be compared directly by equation (1). Liang and McIntosh (1999)
therefore suggest using the risk-adjusted performance (RAP) measure developed by
Modigliani and Modigliani (1997) to make the risks of the two portfolios comparable,
which then allows the two portfolios to be compared on an equivalent return basis.
Unlike the Sharpe Ratio, from which it is derived, Modigliani and Modigliani’s RAP is
measured in basis points, the traditional unit to measure return, and hence allow investors
to easily compare the risk-adjusted performance of alternative investments; where the
RAP of the new portfolio compared with the old portfolio is as follows:
RAPnew old / new (R new R f ) R f (2)
Where: RAPnew is the risk-adjusted performance of the new portfolio, new is the standard
deviation of the new portfolio’s returns, old is the standard deviation of the old
portfolio’s returns, Rnew is the return of the new portfolio, and Rf is the Risk-free rate of
return, as measured by the 3-month T-bill rate.
So after adjusting for the differences in risk between the new and old portfolios, the
difference in return performance can be examined on a comparable basis by:
R new old old / new (R new R f ) (R old R f ) (3)
Page 7However, since the RAP of the new portfolio is sensitive to the allocation to the new
investment i in the new portfolio it needs to be scaled by its weight, wi. So that the
overall benefit (OB) of the new portfolio needs to be calculated as:
OB i [ old / new (R new R f ) (R old R f )] / w i (4)
Where: OBi is the overall benefit of investment i and all the other terms are as before.
When Rnew = Rold (i.e., Rold = Rnew = Ri), Liang and Macintosh (1999) show that the
diversification benefit (DB) of investment i in the new portfolio can be calculated as:
DB i [(R old R f )( old / new 1)] / w i (5)
Alternatively, if the volatilities of the new and old portfolios are the same that is old =
new, the return benefit (RB) of investment i is equal to its overall benefit:
RB i (R new R old ) / w i R i R old (6)
Lastly, the interaction benefit (IB) term between the return benefit and diversification
benefit of investment i with weight (wi) in the new portfolio is calculated as:
IBi [(R new R old )( old / new 1)] / w i (7)
So that OBi = DBi + RBi + IBi. The interaction term is typically small relative to the
diversification benefit and return benefit because it is the product of two second order
terms.
Finally, Liang and McIntosh (1999) show that when the weight of the new investment
tends to zero, the marginal benefit of investment i with an existing portfolio can be
derived by differentiating equations 4, 5, 6 and 7 with respect to w, which gives the
following:
OB i (R i R f ) ( i / old old,i )(R old R f ) (8)
DB i (R old R f )(1 i / old old,i ) (9)
RB i R i R old (10)
IBi 0 (11)
Equations 8, 9, 10 and 11 show a number of features of interest. First, they show that the
overall benefit of an investment can be clearly decomposed into a diversification benefit
and return benefit without the interaction term. Second, equations 8, 9 and 10 show that
once adjustments are made for the different risk characteristics between the new
investment and the existing portfolio the benefits can be stated in return terms. So that
the benefits offered by an investment are directly comparable to the returns of an existing
portfolio. Lastly, equations 8, 9 and 10 show that the benefit of a new investment to an
Page 8existing portfolio is positively related to its returns but negatively related to the risks
between the two investments.
Data and Initial Results
Data for the public real estate market is represented by the Equity REIT (EREIT) index
complied by the National Association of Real Estate Investment Trusts (NAREIT). The
comparable stock and bond indexes are: Large Capital Growth Stocks (LCGS); Large
Capital Value Stocks (LCVS); Small Cap Growth Stocks (SCGS); Small Cap Value
Stocks (SCVS); Long-Term Government Bonds (LTGB), Long-term Corporate Bonds
(LTCB) and Cash (TBs). The data for the growth and values stocks collected from the
French website, while all the other data is collected from Ibbotson Associates (2010).
The study covers the period from 1972:1 to 2009:12, a total of 456 observations.
The analysis conducted on the full sample period (1972:1 to 2009:12) and for three sub-
periods 1972:1 to 1992:12; 1993:1 to 1999:12 and 2000:1 to 2009:12. The selection of
the 1993 cut-off point is the same as that in Lee and Lee (2003); Clayton and
Mackinnon (2003) and Lee et al. (2008) and reflects the structure change in the REIT
industry following the introduction of the Revenue Reconciliation Act of 1993. The
selection of the 2000 cut-off point corresponds to the enactment of the REIT
Modernization Act 1999 and is the same as that used by Liu (2009). The summary data
presented in Table 1 for the full sample period (1972 to 2009) and for three sub-periods
(1972 to 1992 and 1993 to 1999 and 2000 to 2009).
Table 1: Summary Annualised Statistics: Monthly Data 1972 to 2009
Panel A 72-09 REITs LCGS LCVS SCGS SCVS LTGB LTCB T-Bills
Mean 12.6 10.1 12.4 10.6 16.8 8.7 8.6 5.6
SD 17.2 16.8 17.5 24.4 21.5 10.8 9.8 0.9
Correlation --- 0.49 0.66 0.55 0.72 0.11 0.23 -0.03
Panel B 72-92 REITs LCGS LCVS SCGS SCVS LTGB LTCB T-Bills
Mean 14.1 12.0 16.6 14.5 20.2 9.6 9.8 7.5
SD 14.0 18.3 16.2 24.4 20.1 11.4 10.4 0.8
Correlation --- 0.63 0.72 0.74 0.80 0.23 0.27 -0.11
Panel C 93-99 REITs LCGS LCVS SCGS SCVS LTGB LTCB T-Bills
Mean 9.3 20.9 14.9 18.3 15.4 7.9 6.9 4.5
SD 12.4 14.4 11.9 22.1 14.2 8.5 6.7 0.3
Correlation --- 0.27 0.53 0.39 0.62 0.19 0.27 0.05
Panel D 00-09 REITs LCGS LCVS SCGS SCVS LTGB LTCB T-Bills
Mean 11.8 2.0 2.8 6.5 13.3 6.5 6.6 2.9
SD 24.7 15.7 22.9 26.1 28.2 11.5 10.8 0.5
Correlation --- 0.48 0.70 0.48 0.71 -0.03 0.21 -0.00
An examination of Panel A of Table 1 indicates that over the whole sample period (1972
to 2008) the asset class with the highest returns was SCVS (16.8%), while T-Bills showed
the lowest return (5.6%). The asset class with the highest risk was SCGS (24.4%), while
T-Bills showed the lowest risk (0.9%). REITs showed the second highest average return
of 12.6% with a risk which was only the fourth highest (17.2%). The correlation of
REITs is quite high with all stocks, especially large and small cap value stocks,
confirming the results of Acton and Poutasse (1997); Ziering, et al. (1997); Clayton and
Mackinnon (2003) and Lee, et al. (2008) among others. REITs also showed a much
Page 9stronger correlation with corporate bonds (LTCBs) (0.23) than government bonds
(LTGBs) (0.11), supporting the findings of Sanders (1998).
There were substantial changes in the risk/return performance of REITs before and after
the introduction of the Revenue Reconciliation Act of 1993 and the REIT Modernization
Act of 1999. Prior to 1993 REITs showed a mean return that was only the fourth highest
(14.1%) with a risk that was the fifth highest (17.1%). In the period after 1993 and up to
1999 the returns of REITs were the only the fifth highest (9.3%) with a risk which was
the fourth highest (12.4%). After 1999 to 2009 the returns of REITs become the second
highest (11.8%) with the risk the third highest (24.7%).
There were also substantial changes in the correlation between REITs and the other asset
classes before and after 1993. In particular, the correlation of REITs with government
bonds fell substantial confirming the findings of Glascock, et al. (2000) and Swanson, et
al. (2002), while the correlation of REITs with corporate bonds remained relatively
steady, confirming the findings of Sanders (1998). In contrast, the correlation of REITs
with stocks has shown a U-shape over the sample period. Initially the correlation of
REITs with stocks declined from sub-period one (72-92) to sub-period two (93-99),
which confirms the findings of Ghosh, et al. (1996); Clayton and Mackinnon (2001 and
2003; Chandrashekaran (1999); and Conover et al (2002) among others, but the results
also show substantial increases from sub-period two (93-99) to sub-period three (00-09),
which is supportive of the work of Cotter and Stevenson (2006); Chong et al (2009) and
Case et al (2010). Also, the correlation of REITs with both large and small value stocks
has always been greater than that for REITs with growth stocks, indicating that REITs are
a value stock, due to its large income component, which confirms the findings of Clayton
and Mackinnon (2001 and 2003); Mueller et al. (1994); Liang and McIntosh (1998);
Sanders (1998); Ziering, et al. (1999); Stevenson (2001); and Chiang and Lee (2002); and
Ghosh, et al. (1996) among others.
Taken together the results in Table 1 suggest that the overall benefit of REITs to the
alternative asset classes would have been relative high with growth stocks, with the
benefit coming from the return and diversification benefits of REITs. The benefits to
large value stocks should be much lower with the benefit mainly coming from the return
performance of REITs, while, REITs should offer very little to small cap value stocks. In
contrast, REITs should offer higher overall benefits to fixed interest securities with the
impact coming from both return and diversification benefits. A view confirmed in Table
2, which presents the annualised overall benefit, diversification benefit and return benefit
of REITs to the alternative asset classes over the sample period (1972 to 2009) and for the
three sub-periods 1972 to 1992, 1993 to 1999 and 2000 to 20091.
1
Remember we estimate the overall benefit, diversification and return benefit of REITs to the alternative
asset classes in percentage terms, on a risk-adjusted basis, using equations 8 to 10 respectively.
Page 10Table 2: Annualised Overall, Diversification and Return Benefits of REITs:
Monthly Data 1972 to 2009
Panel A 72-09 LCGS LCVS SCGS SCVS LTGB LTCB T-Bills
Overall 4.75 2.52 5.02 0.55 6.48 0.48 7.00
Diversification 2.29 2.38 3.07 4.76 2.59 0.15 ---
Return 2.46 0.15 1.95 -4.21 3.89 0.33 7.00
Panel B 72-92 LCGS LCVS SCGS SCVS LTGB LTCB T-Bills
Overall 4.41 0.88 3.58 -0.53 5.98 5.75 6.58
Diversification 2.35 3.41 4.07 5.65 1.56 1.50 ---
Return 2.07 -2.53 -0.49 -6.17 4.41 4.25 6.58
Panel C 93-99 LCGS LCVS SCGS SCVS LTGB LTCB T-Bills
Overall 0.97 -0.85 1.78 -1.06 3.89 3.62 4.81
Diversification 12.56 4.71 10.71 5.04 2.47 1.17 ---
Return -11.59 -5.57 -8.93 -6.10 1.42 2.45 4.81
Panel D 00-09 LCGS LCVS SCGS SCVS LTGB LTCB T-Bills
Overall 9.51 8.92 7.25 2.40 9.09 7.10 8.86
Diversification -0.20 -0.02 1.96 3.96 3.85 1.90 ---
Return 9.71 8.94 5.29 -1.56 5.24 5.20 8.86
Table 2 shows a number of features of interest. First, Panel A of Table 2 shows that over
the whole sample period REITs offered better overall benefits to bonds compared with
stocks. The overall benefit of REITs to LTGBs and LTCBs comes from both its
diversification benefits and return benefits. In contrast, the benefit of REITs to stocks
mainly coming from the diversification benefit of REITs.
Second, in line with the arguments above Panels B, C and D of Table 2 show that the
benefits of REITs to the alternative asset classes have changed considerable over time.
For instance, in the first and second sub-periods REITs showed its greatest benefit to
growth stocks and bonds and least to value stocks, with its benefit coming mainly from
its diversification benefits. By way of a contrast, in the period after 1999 REITs showed
a strong overall benefit to all stocks and bonds, due to the good return performance of
REITs outweighing the poor diversification benefits of REITs over this period.
Mixed-Asset Results
In order to examine the benefits of REITs to the mixed-asset portfolio (MAP) three
capital-market portfolios were defined, which both contained an allocation to stocks of
and bonds, but with differing weights in large and small cap stocks and bonds2. The
analysis undertaken for the overall sample period (1972 to 2008) and for the three sub-
periods before and after the Revenue Reconciliation Act of 1993 and the the REIT
Modernization Act 1999. The results presented in Table 3.
Table 3 shows a number of features of interest. First, Table 3 shows that over the whole
2
For the first portfolio the allocation was, 22.5% in LCGS and LCVS, 10% in SCGS and SCVS, 20% in
LTGBs, 10% in LTCBs and 5% Cash, i.e. a large cap dominated mixed-asset portfolio. While, the second
portfolio contained 10% in LCGS and LTVS, 22.5% in SCGS and SCVS, 20% in LTGBs, 10% in LTCBs,
and 5% Cash, i.e. a small cap dominated mixed-asset portfolio. Finally, a bond dominated portfolio was
constructed with 10% in LCGS, LCVS, SCGS and SCVS respectively, 35% in TLGB, 20% LTCBs, and
5% Cash i.e. a fixed-interest dominated mixed-asset portfolio.
Page 11sample period REITs offered the greatest benefits to the MAP with a large allocation to
bonds closely followed by large cap stocks and small cap stocks. Second, in line with the
findings above the benefit of REITs to the MAP has changed over the three sub-periods.
In the first sub-period REITs offered both diversification and return benefits to the MAP.
By way of a contrast, the benefit of REITs was negative in the second sub-period, due to
the diversification benefit of REITs being overwhelmed but its poor return benefit. While
in the last sub-period REITs have offered strong return benefits and negative
diversification benefits, as once again REIT returns have shown a strong positive
correlation with stock market returns. These changes in the evolution of the benefits of
REITs to the mixed-asset portfolio are shown graphical in Figures 1, 2 and 3.
Table 3: Annualized Benefit of REITs to the MAP:
Monthly Data 1972 to 2009
Panel A Large Cap 72 to 09 72 to 92 93 to 99 00-09
Overall 2.36 2.08 -1.60 7.97
Diversification 0.48 1.21 3.00 -0.61
Return 1.88 0.87 -4.59 8.58
Panel B Small Cap 72 to 09 72 to 92 93 to 99 00-09
Overall 2.15 1.64 -1.16 6.38
Diversification 0.88 1.55 3.17 -0.48
Return 1.27 0.09 -4.33 6.86
Panel C Bonds 72 to 09 72 to 92 93 to 99 00-09
Overall 2.55 2.71 -0.75 4.95
Diversification 0.01 0.70 1.24 -1.94
Return 2.53 2.01 -1.99 6.89
To achieve a graphical representation of the changes in the benefit evolution of REITs,
we estimate Liang and MacIntosh’s (1999) approach using a rolling window of 24
months and obtain 421 evolving overall benefits, return benefits and diversification
benefits from 1973:12 to 2009:12. Figures 1, 2 and 3 also show the periods of recession
in the US, as defined by the NBER, together with the periods of booms and busts in the
private real estate market and stock markets.
Figure 1 provides some evidence of the changes in the benefits of REITs to the MAP,
which is dominated by large cap stocks. For instance, up to the end of the ‘oil price
recession’ in June 1975 REITs showed negative return and diversification benefits to the
MAP, resulting from the use of short-term debt and the large development exposure of
REITs at this time. In contrast, in the real estate boom up to the end of 1978 REITs
showed a strong return benefit but little or no diversification benefit, due to the pent-up
demand following the real estate crash and the switch by REITs into long-term debt.
Then as the stock market boomed up to the crash in October 1987 REITs displayed a
good return benefit as well as a good diversification benefit, due to the small cap
characteristics of REITs. However from November 1987 the return benefit disappeared
and was not covered by the diversification benefit, due to the impact of the real estate
market crash until the dawn of the ‘New REIT Era’.
Following the start of the ‘New REIT Era’ REITs showed relatively good return benefit
until the start of the dotcom bubble when growth stocks dominated the performance of
the US stock market until the bubble burst in February 2000. After which the strong
Page 12‘value’ component of REITs meant that the return benefit increased dramatically until the
start of the ‘credit crunch’ since when the return benefit of REITs has turned negative,
while the diversification benefit of REITs has once again reappeared, due to the strong
rebound in REIT returns.
Figure 2, which examines the benefit of REITs to the MAP dominated by small cap
stocks, shows a very similar picture as Figure 1. However, the overall benefits, return
benefits and diversification benefits are much smaller than for a large cap dominated
portfolio, confirming the results in Table 3. This implies that REITs are small cap stocks
and so provide only minor benefits to the small cap stock dominated MAP.
Lastly, Figure 3 provides some evidence of the changes in the benefit of REITs to the
mixed-asset portfolio dominated by bonds and shows a very similar ebbs and flows in the
return and diversification benefits of REITs as in Figures 1 and 2. The main feature of
Figure 3 however is that REITs for the most part offer a return benefit and very little
diversification benefit to bond dominated portfolios, confirming the results in Table 3.
Conclusions
A number of studies have examined the allocation of public real estate securities (REITs)
in the mixed-asset portfolio with contradictory results. Yet no study has examined
whether REITs are a return enhancer, diversifier or both? Using monthly data from
1972:1 to 2009:12 and the method suggested by Liang and McIntosh (1999), the results
show that REITs offer different benefits to different asset classes and the MAP and that
these benefits have changed substantially over time in line with the changes in the
evolution of the REIT industry.
Prior to 1999 REITs showed a strong diversification benefit to large cap growth and value
stocks but a negative return benefit. However, since 1999 the benefit of REITs to large
growth and value stocks now comes from its return enhancement benefits rather than any
diversification benefit. The benefit of REITs to small cap growth stocks initially coming
from its diversification benefit but since 1999 now comes from both its return and
diversification benefit. While the return benefit of REITs to small cap value stocks has
always been negative. By way of a contrast, REITs have always shown strong
diversification and return benefits to both corporate and government bonds. The
changing the benefits of REITs to the various asset classes are also reflected in the types
of benefits REITs offer the MAPs. Thus, whether REITs can have a place in any future
mixed-asset portfolio largely depends on the relative return performance of REITs versus
the alternative asset classes within the mixed-asset portfolio.
Lastly, the changes in the benefits of REITs to the alternative asset classes imply that any
studies of the long-run performance of REITs need to take account of the structural
changes in the REIT industry or are likely to make erroneous conclusions.
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Page 20Figure 1: The Rolling Overall, Diversification and Return Benefits of REITs to the Large Cap Mixed-asset Portfolio: 1973:12 to 2009:12
25 Annualized Return
The 'New REIT Era' The Credit
Benefits % Recessions
Crunch
20
Overall Benefit %
15
Stock
Market
10 Crash
5
0
Real Estate
Market Boom
-5
Diversification
-10 Return Benefit %
Benefit %
Real Estate
-15
Market Crash
-20
-25 End of Dotcom
Bubble
-30
Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec-
73 75 76 78 79 81 82 84 85 87 88 90 91 93 94 96 97 99 00 02 03 05 06 08 09
Page 21Figure 2: The Rolling Overall, Diversification and Return Benefits of REITs to the Small Cap Mixed-asset Portfolio: 1973:12 to 2009:12
25 Annualized Return Recessions The 'New REIT Era' The Credit
Benefits % Crunch
20
Real Estate Overall Benefit %
15 Market Boom
Stock
10 Market
Crash
5
0
-5
Return
Diversification
Benefit %
-10 Benefit %
Real Estate
Market Crash
-15
-20
End of Dotcom
-25
Bubble
-30
Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec-
73 75 76 78 79 81 82 84 85 87 88 90 91 93 94 96 97 99 00 02 03 05 06 08 09
Page 22Figure 3:The Rolling Overall, Diversification and Return Benefits of REITs to the Bond dominated Mixed-asset Portfolio: 1973:12 to 2009:12
25 Annualized Return The Credit
Recessions The 'New REIT Era'
Benefits % Crunch
20
Overall Benefit %
15
10 Stock
Market
Crash
5 Real Estate
Market Boom
0
-5
-10
Real Estate
Diversification
-15 Return
Market Crash Benefit %
Benefit %
-20
End of Dotcom
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