Does real estate deliver diversification when needed the most? - A dynamic conditional correlation study of REITs in a mixed-asset portfolio

Abstract

Real estate has traditionally been favored in a mixed-asset portfolio due to its risk-return characteristics and diversification benefits. The recent global financial crisis challenged this perception of advantages attributed to real estate. This thesis aims to examine the relationship between REIT returns and the returns of equity, fixed income, money market and commodities on the US market by examining the dynamic conditional correlations employing the DCC-GARCH(1,1) model. If the relationship strengthens in a downturn market, a portfolio might lose some of its level of diversification when it is needed the most. The findings presented in this thesis suggest that the conditional correlation between REIT and that of equity, fixed income, money market and commodities is time-varying and increases during bear markets. The empirical study led to three primary findings. Firstly, REIT and equity exhibit a moderate to strong positive relationship throughout the sample period. Secondly, despite a somewhat blurry relationship the commodity index seems to behave and react differently to REIT and thus provide potential benefits of diversification. Thirdly, REIT’s relationship with fixed income as well as money market provide diversification opportunities. The results of this thesis suggest that investors heavy in the commodity and money market should find allocation towards REIT of particular interest in terms of seeking portfolio diversification.