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Abstract
This study presents evidence of cointegration between securitized (NAREIT) and direct (NCREIF) real estate total return indices. Since the two real estate indices are cointegrated with one another but not with the stock market, real estate investment trusts (REITs) and direct real estate are likely to have similar long-term diversification benefits in a stock portfolio. Only direct real estate is found to currently adjust towards the cointegrating relation, with NAREIT returns leading NCREIF returns. However, the results show evidence of the predictability of NAREIT returns during the 1980s. Additionally, a large and long-lasting deviation from the long-run relation between NAREIT and NCREIF is identified at the beginning of the "new REIT era."
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The contemporaneous correlation between the returns on direct and indirect real estate investments is typically found to be weak. In contrast, indirect real estate returns have generally been found to closely resemble general stock market returns. Several factors may explain the lack of significant contemporaneous correlation between securitized and unsecuritized real estate returns. For instance, in several studies the use of appraisal-based real estate indices is likely to bias the contemporaneous correlations downwards. Furthermore, securitized real estate prices may embed stock market noise that is not related to the fundamentals driving real estate returns.
Much of the low correlations observed can probably be attributed to the sluggish adjustment of direct real estate prices to shocks in the fundamentals. Due to the higher liquidity, greater number of market participants, smaller transaction costs, and the existence of a public market place in the securitized market, the indirect real estate market is generally more informationally efficient than the direct market. Therefore, the prices of indirect real estate investments should react faster to shocks in the fundamentals than those of direct real estate. Indeed, empirical evidence shows that the securitized market leads the direct real estate market (Gyourko and Keim, 1992; Myer and Webb, 1993; Barkham and Geltner, 1995; Li, Mooradian, and Yang, 2009).
A positive lead-lag relation between securitized and direct real estate returns diminishes the short-horizon correlations relative to the longer-horizon correlation figures. As in the long run both markets should adjust to shocks in the fundamentals and the impact of noise in securitized real estate prices should...