Commodities vs. REITS

Investors have become increasingly interested in commodities and REITs (real estate investment trusts) for a similar reason. Both are "real asset" classes that tend to react to changing economic conditions in ways that are different from financial assets such as stocks and bonds. From an investor standpoint, the differences often play out in the form of low correlations to traditional asset classes.

As a quick primer, correlation ranges between -1 and +1. A correlation of +1 implies that as one security moves, the other security will move in lockstep. Alternatively, a correlation of -1 means that if one security moves, the other security will move by an equal amount in the opposite direction. If the correlation is 0, the movements of the securities are completely random.

Do REITs and commodities deserve their reputation for having low correlations to equities? And which is the better diversifier?

Let's take a look.

REIT Returns Explained

For the uninitiated, REITs are structured much like a mutual fund, except rather than owning shares of companies, they own, develop, acquire and manage property. This can include shopping centers, regional malls, hotels, apartments, mobile home parks and office buildings.

Though REITs have a historical reputation for offering strong diversification, there are qualifiers. According to REITCafe.com, the correlation between REITs and the broader markets has been moving higher recently. In fact, the correlation between REITs and the major equity indices is currently at, or near, all-time highs. As of April 18, 2008, the correlation between the MSCI REIT Index and the Dow Jones Industrial Index was 0.745. The correlation with the NASDAQ Composite Index was 0.706, while the correlation with the S&P 500 Index was 0.771.

 

 

As further proof, there are two domestic REIT ETFs from iShares, both with long track records: the Dow Jones US Real Estate (IYR) and the Cohen and Steers Realty Majors (ICF). According to PortfolioScience.com, IYR has 0.758 correlation to the S&P 500 and ICF has 0.701 correlation.

Does this mean that diversification by REITs is a myth? Not really. The fact is that REITs are an asset class that rise and fall, and though the short term shows relatively high correlations, over the long term, there does appear to be a systematic low correlation of REITs to the broader markets.

As seen in the chart below, the correlation of REITs to the broader markets has mostly run on five-year cycles. A past cycle began with REITs showing a relatively low correlation to the broader markets, and then correlation increases for three to four years, and then finally, moves down for one year.

 

 

A better understanding of the data comes from considering what drives REIT returns.

In terms of REITs' relationship to the bond market, many investors believe that when interest rates rise, REIT prices will fall. That's not quite right: Rising rates slow down new real estate construction, thereby making existing properties more valuable. Small amounts of interest rate increases, especially as the economy is expanding, may actually enhance REIT returns. In fact, returns came on very strong after the Fed started raising interest rates in May of 2004.

Ultimately, if interest rates rise high enough, it will mean lower returns for REITs due to vacancies caused by an economic slowdown. The REITs themselves will then become less attractive, as the spread between their dividend yields and the 10-year Treasury yields will fall.

A similar metric is at work with equities. In other words, REITS work best as diversification-plays when interest rates are rising slowly. If interest rates get jacked up too high, REITs can fall with other assets.

What About Commodities?

Commodities tend to bear a low-to-negative correlation to traditional asset classes like stocks and bonds. The explanation is that commodities are a bet on unexpected inflation and that unexpected inflation is bad for other assets.

The data bears this out and shows that commodities may be a stronger diversification play over time than REITs. Returns from a broad and diversified commodity index such as the Dow Jones AIG Commodity Index have historically been independent of stock and bond returns, but positively correlated with inflation. From December 1990 to March 2006, quarterly returns on the Dow Jones-AIG Commodity Index have been negatively correlated with both the S&P 500 and the Lehman Brothers Aggregate Bond Index (LBAG), and positively correlated with both the CPI and the quarterly change in inflation.

 

Correlation of Quarterly Returns

(Quarterly Returns December 1990 - March 2006)

Source: Bloomberg Financial Markets and Bureau of Labor Statistics

 

Occasionally, the commodities-equities relationship undergoes short-term blips, and it's not uncommon to see some positive correlations between commodities and equities over short periods. Over a longer period of time, negative correlations win out. In a December 2007 research paper titled "Commodities and Equities: A Market of One?" authors and commodity trading experts Bahattin Buyuksahin, Michael Haigh and Michel Robel refute the idea that commodity and equity returns move in sync over a sustained period. They provide ample evidence that shows the relationship between returns on commodities and equities has not changed significantly over the past 15 years. They find no evidence of an increase in correlation, even during periods of extreme returns. For example, between 1992 and 2007, the Deutsche Bank Liquid Commodity index posted positive returns 60% of the time when equity returns were negative. It also outperformed cumulative returns in fixed income markets over that time. When the S&P 500 moved lower in June and July last year, the DBLCI-MR posted positive returns for more than 5% each month.

Importantly, the link between commodities and inflation should not break down as interest rates rise too high. The breaking point only comes when global economic activity is slowed by high commodity prices, thereby reducing demand, or when new commodity supply comes on line-a process that can take years.

Conclusion

REITs and commodities do offer diversification versus the broader equity markets, though perhaps not as pronounced as investors might have expected. Clearly, all of the major asset classes initially react in similar fashion to changing economic conditions. But over time, the fundamentals start to weigh in. The market values the long-term impact of a macro trend like inflation on a bushel of corn, a bar of gold or an office building differently than they value its impact on a company's stock or on a government bond. It's not simply diversification, but the actual timing of that diversification that investors should keep in mind when considering investing in REITs or commodities.

 

Comments

[GlobalWarmingExaminer]

I liked your article. Lots of good background on REITS and Commodity investing. In regards to REITS, the current credit crunch is limiting the availability of funds to property developers, thereby reducing supply. This has the same positive effect on existing properties as high interest rates without the actual cost of higher rates. This should be a positive for the large, existing, quality REITS. If anyone on the site has suggestions on specific REITS that might benefit, I am interested.