Do Real Estate Prices and Stock Prices Move Together? an International Analysis
Quan, Daniel C., Titman, Sheridan, Real Estate Economics
A number of authors have argued that commercial real estate offers diversification benefits to institutional investors because of its low correlation with commonly used stock price indexes. For example, using annual U.S. data from 1947 to 1982, Ibbotson and Siegel (1984) found real estate's correlation with SP stocks to be -.06, whereas Hartzell (1986), using quarterly data from 1977 to 1986, estimated the correlation to be -.25. Worzala and Vandell (1993), using the Frank Russell Index and more recent quarterly data from 1980 to 1991, estimated the correlation to be -.0971. Worzala and Vandell (1993) estimated the U.K. real estate correlation with stock returns to be .039. More recently, Fu and Ng (1997) cite a low contemporaneous correlation between a transactions-based real estate index and stocks for Hong Kong over the period 1980 to 1996. Eichholtz and Hartzell (1996) document correlations of -.10, -.08 and -.09 for Canada, the U.K. and the U.S. between property and stock indexes(1).
The low correlation between real estate and stock price indexes is somewhat surprising, given that both are affected by the level of economic activity and interest rates. However, other factors can reduce the correlation between the two time series. For example, stock prices may increase because of increased investment opportunities in an economy's corporate sector. This increase in investment opportunities could in turn lead to increases in real interest rates, which could reduce the value of commercial buildings even if their rental prices increase. Changes in the cost of labor could also induce a negative relation between stock prices and commercial real estate values. For example, foreign competition may lead to decreases in domestic wage rates, which in turn lead to increased corporate profits and higher stock prices. However, if wage rates in the building sector also decrease, then construction costs decline, and the value of commercial real estate will fall. Hence, changing labor costs can lead to negative correlations between commercial real estate values and stock prices.
Real estate will indeed provide substantial diversification benefits for pension funds and other institutions if the low correlations between real estate and stock price indexes arise because the values of these capital assets react very differently to economic factors. However, the low observed correlation could alternatively be an artifact of the data. Because real estate trades infrequently, researchers must rely on indexes based on appraisals or inferred prices. Due to the nature of this inferring process, such indexes are often smoothed and thus underestimate the true volatility of the commercial real estate time series as well as the covariance between real estate price changes and stock returns. Hence, commercial real estate may provide less diversification benefit than would be indicated by a naive interpretation of the data.
This paper provides new evidence on the relation between stock returns and real estate price changes by analyzing real estate price indexes, stock prices and macroeconomic data from 17 countries. These countries include most of the world's largest industrialized economies as well as some of the smaller economies in Asia's emerging markets.
In contrast to earlier studies, we find a significant positive relation between stock returns and changes in commercial real estate values. After establishing this relation, we estimate additional regressions that provide some insights into why these two return series are correlated. One hypothesis is that real estate and stock prices are both driven up and down by changing expectations (either rational or irrational) of future economic growth that is independent of current fundamentals, like current rents and GDP. For example, in Japan, people often refer to the "bubble economy" in the mid-1980s which was characterized by real estate and stock prices being bid up to levels that could not be sustained. …