The Changing Fortunes of Residential Real Estate Investments

Introduction

In recent years, the residential real estate asset class has faced mixed results. Investors seeking diversification in their portfolios look for an asset class that can provide long-term returns while exhibiting a low correlation with the stock market. By achieving these goals, the inclusion of such an asset class in a stock portfolio can mitigate risk, resulting in an overall superior risk-adjusted return.

Historical Performance

Historically, residential real estate has proven its mettle by generating profits during most stock bear markets since the 1950s. However, the same cannot be said for the bear market of 2022 and the subsequent bull market.

To assess the performance of the residential real estate market, it is useful to examine the iShares Residential and Multisector Real Estate ETF (REZ). While this ETF does not solely represent the residential real estate asset class, it serves as a convenient investment vehicle for individual investors.

During the 2022 bear market, REZ experienced a significant loss with a total return of -29.2%, compared to a -24.5% return for the S&P 500 index. Since then, REZ has only managed to gain 8.3% while the S&P 500 soared by 39.7%.

Correlation Concerns

Despite disappointing returns, there remains a possibility for REZ to enhance the risk-adjusted returns of a stock portfolio if its returns show a sufficient lack of correlation with the stock market. Unfortunately, as illustrated in the accompanying chart, there appears to be a high degree of correlation between REZ and the S&P 500. This observation holds true over the ETF’s entire history, with a correlation coefficient of 0.68 between its monthly returns and those of the S&P 500 since its inception in 2007.

In conclusion, residential real estate investments have faltered in recent times, failing to deliver the expected returns and correlation benefits. Investors looking to diversify their portfolios must consider alternative asset classes that offer a more promising risk-return profile.

A Flawed Representation

Allocating a small portion of an equity portfolio to REZ does not improve risk-adjusted performance. However, there’s still hope.

Imperfections in REZ

The REZ is not a perfect representation of the residential real estate market. Its largest holding, Welltower, is a healthcare infrastructure company, while its second largest holding is Public Storage REIT, which operates self-storage facilities. This does not criticize REZ since it openly focuses on both residential and “multisector” real estate.

Seeking a Better Alternative

A fund that solely represents the residential estate market would have a much lower correlation with the stock market. The Case-Shiller U.S. National Home Price Index supports this claim, as its correlation coefficient with the S&P 500 is merely 0.15 compared to REZ’s coefficient of 0.68 (see accompanying chart). Allocating a portion of your equity portfolio to the Case-Shiller index can potentially improve risk-adjusted performance.

Unfortunately, such a fund does not exist yet. As a result, residential real estate remains an enticing but unattainable diversifier for equity portfolios.

Variability in Performance

Investing in residential real estate still has its merits. However, it is important to acknowledge that your performance may differ significantly from that of the asset class as a whole. Various unique factors impact the price of real estate properties, causing divergences in performance.