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Correlation and diversification

Low Correlation


A result of residential’ s low volatility and consistently strong returns over an extended period is the fact it
exhibits low correlation with other, more volatile asset classes such as equities and commercial property.
Residential demand (in terms of rents as an income return or housing demand as a capital driver) is relatively inelastic with regard to GDP growth, unlike corporate earnings or commercial office space.

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Diversification


This section considers diversification at two key levels, across the asset class and between other asset classes.

Diversification across the asset class:
  • 1 bedroom flats have different dynamics when compared with 5 bedroom detached houses,
  • Prime London property has different dynamics compared with, say, that of mid-Wales.
Concentration risk can be reduced by diversifying across different types of properties in different locations in the same way that an equity investor can buy shares in a variety of companies in different sectors.

With residential property assets, certain national economic factors, such as the general availability of mortgage finance, will affect prices across the UK, so one would expect to see positive correlation between all residential properties.
 
However, local economic factors such as changes in employment, infrastructure, etc. will have significant influence on capital and rental values in the immediate vicinity. An experienced residential property fund manager will take all of these factors into account when selecting assets for the fund portfolio.

Diversification between other asset classes:The following table shows that residential property has very low correlation with equities, fixed interest and cash over the medium to long term.

It is no surprise that for the period 2005-12 correlation with other assets became more significant due to the effects of the global credit crunch, but one would anticipate correlation to move closer to historic levels once markets return to a degree of normality and trade on fundamentals rather than the current sentiment of fear and worldwide contagion.

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