Correlation and Volatility Dynamics in REIT Returns: Performance and Portfolio Considerations

Abstract

We examine the dynamics in correlations and volatility of REITs, stock and direct real estate returns using the monthly data from Jan 1987 to May 2008. To explore asymmetries in conditional correlation, the multivariate asymmetric dynamic diagonal conditional correlation (AD‐DCC) GARCH specification is utilized in this paper. We document that the time‐varying conditional correlations can be explained by macroeconomic variables such as the term and credit spreads, inflation and the unemployment rate. We also find strong relationship between correlations and REITs returns, while those patterns are distinguishable for different types of REITs.

Interestingly, when the correlation between REITs and S&P are the lowest, the future performance of REITs is the best. For equity REITs, there exists a robust relationship between correlations and future returns: the higher (lower) correlation between equity REIT and direct real estate is, the higher (lower) the future returns of equity REIT. Ourresults also have significant economic implications regarding the time-dependent diversification benefits of REITs in a mixed-assets portfolio and the unique risk and return characteristics of REITs.

Keywords: Dynamic Conditional Correlation, REIT returns, Real Estate, Diversification

JEL Classification: G11, G15