Executive Summary. Previous research establishes that Federal Reserve monetary policy influences both stock and bond returns. This research extends past research and shows that similar patterns exist for real estate investment trust returns. We find that the correlation structure of asset returns changes with alternative monetary policy environments. Mean-variance analysis indicates that optimal asset allocations differ dramatically in different monetary policy environments, and that the exposure to real estate should be prominent only in expansive environments. Overall, the findings suggest that investors may wish to realign their portfolios in reaction to, or anticipation of, Federal Reserve actions.
The relationship between Federal Reserve monetary policy and security returns has been recognized for many years. The conventional view suggests that a restrictive monetary environment serves as bad news and is generally associated with higher future interest rates and decreases in the level of economic activity. In contrast, an expansive environment is commonly viewed as good news as these periods are usually associated with lower future interest rates and increases in economic activity. Fridson (1998) explains that when the Federal Reserve loosens its grip on the money supply, stock prices benefit in several ways. First, the corporate earnings outlook improves. Reduced interest rates enable companies to build up their inventories and increase customers' credit lines. To the extent that price-earnings ratios determine equity values, a jump in earnings necessitates a jump in the index. A second, more direct impact on stock prices derives from the increased availability of loans for financing security purchases. Finally, a drop in interest rates reduces the attractiveness of fixed-income investments, relative to equities. The logical consequence is a shift of investment capital from bonds to stocks.
Early researchers, including Sprinkel (1964, 1971), Palmer (1970), Homa and Jaffee (1971), Hamburger and Kochin (1972) and Modigliani (1972) report evidence that changes in Federal Reserve Policy influence equity prices. Recently, Jensen and Johnson (1995), Jensen, Mercer and Johnson (1996), Jensen, Johnson and Bauman (1997) and Jensen, Johnson and Mercer (2000) identify longterm patterns in equity returns correlated with Fed monetary policy. In particular, stock and bond returns are shown to be significantly higher in periods characterized by an expansive policy than security returns during restrictive monetary periods.
Previous researchers have investigated the association between the performance of the real estate market and interest rates, in general, and Federal Reserve monetary policy in particular. Hemel, Sakwa and Bhattacharjee (1995) and Mueller and Pauley (1995) found that real estate investment trust (REIT) price movements had a low positive correlation with changes in bond prices (i.e., negative correlation with interest rates) and a lower correlation with interest rates than with movements in the stock market as a whole. Gyourko and Linneman (1988), Murphy and Klieman (1989) and Park, Mullineaux and Chew (1990) found that REIT returns were negatively correlated with expected inflation. Finally, Darrat and Glascock (1989) concluded that monetary policy measures have significant lagged relationships with current REIT returns.
The objective of this study is to examine the implications that previous monetary policy research has for asset allocation decisions in the area of real estate. Returns to various REIT indices, as well as other capital market indices, are examined. In addition, using mean-variance analysis, asset allocation to real estate is examined in alternative monetary policy periods. The findings highlight the importance of monetary conditions on real estate market performance and asset allocation decisions.
Data and Methodology