The actual return correlation between two assets has nothing to do with whether they’re listed (public) or unlisted (private). The reason that people have made the mistake of thinking that private real estate has a low correlation with listed real estate is that the measurement of private real estate returns lags behind actual returns. This happens for two reasons:
(1) Illiquidity means that, even when a property is sold, it takes a long time—several months, typically—for the buyer and seller to agree on a price and to close the transaction. Because the true market value of the asset changes daily, in the real world it’s never true that the price paid in a transaction with a particular closing date is equal to the true market value of that asset on the same day. In contrast, liquid (“Tier 1”) assets, such as listed REIT stocks, transact within seconds after the buyer and seller agree on the price.
(2) Appraisals typically take a long time to perform, and generally must be based on observations of previously completed transactions of comparable assets. Moreover, because they’re expensive, appraisals are done infrequently—typically once a year now, although once every three years was the norm over most of the time that data has been collected. That’s three sources of delay: appraisals happen after the (delayed) sales of comparable properties, appraisals take a long time, and the most recent appraisal is used for a long time before a new one replaces it.
As a result, measured private real estate returns lag dramatically behind actual private real estate returns. To see how important the private real estate lag is, just look at the correlations between listed REIT indexes and their own lagged values. The correlation between the FTSE NAREIT Equity REIT Index and its own lagged returns is just 0.158 assuming a 12-month lag!
So, private real estate does NOT actually have a low correlation with public real estate. That shouldn’t be surprising: in fact, there’s no reason for anybody to have supposed otherwise. The value of any asset, including a property (held publicly or privately), is determined by two factors: the future stream of (net) income that the owner expects to get from that property, and the appropriate discount rate to use in converting each future (net) income payment to its present value. Whether the property is held publicly or privately has no effect on its future earnings. The high risk associated with illiquidity means that the discount rate for privately held properties is higher than for publicly held properties (that is, the property is worth less under private ownership than under public ownership), but there is no difference between public and private ownership in terms of how the discount rate changes over time. That means returns—the changes in the value of the property over time, plus the income it produces—do not depend on whether the property is held publicly or privately.
Think of any portfolio held by a listed REIT, and then pretend that somebody bought up all the REIT’s stock—thereby taking it private—without making any other change in the portfolio. Why on earth would its returns change? The only difference is that, as a portfolio held privately, its returns would be measured with a significant lag caused by illiquidity and the use of appraisals. That’s not a difference in returns, that’s an error in measuring them; it doesn’t produce a low correlation, only a false one.
Click here for a bibliography of independent academic studies on the relationship between private and public real estate, with a quotation from each study and a link to find it online.
Brad Case is senior vice president, research & industry information for the National Association of Real Estate Investment Trusts (NAREIT). Dr. Case has researched residential and commercial real estate markets, domestically and globally, for more than 25 years. His research encompasses investment return characteristics including returns, volatilities, and correlations with other assets; measuring appreciation in property values; inflation protection; use of DCC-GARCH and Markov regime switching models to measure and predict investment characteristics; the length of the real estate market cycle; and the role of the investment horizon. He holds patents as the co-inventor of the FTSE NAREIT PureProperty(r) index methodology and the backward-forward trading contract. Dr. Case earned his Ph.D. in Economics at Yale University, where he worked with Robert Shiller and William Goetzmann, and holds the Certified Alternative Investment Analyst (CAIA) designation.