The Risk and Return Characteristics of Stock Market-Based Real Estate Indexes and Their Relation to Appraisal-Based Returns

Despite its importance to our national wealth, real estate remains a relatively unstudied asset. A key reason for this is the perceived limitations of available return data. Most research in the area relies on the appraisal-based series such as the Frank Russell Company (FRC) index. This paper suggests that the stock market provides a ready source of transactions-based data. Many real estate researchers are skeptical of stock market data because the studies of real estate investment trusts (REITs) find that their returns are more correlated with the broader stock market than with other known real estate series. A typical conclusion is that traded real estate securities do not accurately reflect real estate values. We argue that such conclusions are premature. We simulate the returns and risks of portfolios of different types of real estate firms using historical stock prices for the 1962-1988 period. We use the time series of the real estate portfolio returns to estimate the correlation structure of returns among real estate securities, common stocks, long-term Treasury bonds, and inflation. Estimation of factor models documents a particularly strong small stock component to traded real estate stock returns. We also find substantial heterogeneity in return patterns across different types of real estate firms. Finally, we demonstrate that our real estate portfolios are not unrelated to appraisal-based indexes. Lagged values of the real estate portfolio returns can predict returns on the FRC index.