Why Does Diversification Matter?
Harry Markowitz introduced Modern Portfolio Theory (MPT) in 1952, revolutionizing investing by demonstrating that diversification can optimize returns for a given level of risk. MPT emphasizes that an investor should construct a portfolio of assets with low or negative correlations to minimize volatility while maximizing expected returns. MPT suggests that true diversification is achieved by holding assets with low or negative correlations, rather than merely increasing the number of holdings.
When evaluated through this lens, direct commercial property ownership emerges as a superior diversifier compared to REITs.
Correlation and Diversification
Diversification reduces portfolio risk by including assets that do not move in tandem. Traditional stocks and bonds often exhibit inverse correlations, but real estate provides an alternative asset class with unique risk-return characteristics. The key to effective diversification is low correlation—assets that react differently to economic cycles, inflation, and interest rate changes.
Listed REITs, while classified as real estate investments, behave much like equities due to their public market listing. Their price movements are influenced by market sentiment, liquidity flows, and broader macroeconomic factors, leading to higher correlations with stocks than with direct property holdings. Historical data suggests that UK-listed REITs tend to exhibit correlation coefficients of 0.5 to 0.7 with equity indices, indicating a strong relationship with the stock market[1].
In contrast, direct commercial property ownership has a significantly lower correlation with equities, often in the range of 0.1 to 0.3. This is because private real estate valuations are based on appraisals rather than continuous market pricing, reducing volatility and insulating them from daily market sentiment. Direct property values also depend more on local supply-demand dynamics, lease structures, and tenant creditworthiness, rather than investor speculation.
Stability and Risk Management
REITs are subject to stock market volatility, experiencing price fluctuations that may not align with the intrinsic value of the underlying real estate assets. During financial crises, such as the 2008 global downturn or the COVID-19 market shock, REIT prices fell in tandem with equities, diminishing their role as a portfolio diversifier.
Conversely, direct commercial property ownership provides a stable income stream through rental yields, and its illiquid nature shields it from speculative trading. The absence of daily pricing mechanisms means property values adjust more slowly, reducing overall portfolio volatility. This stability is particularly valuable for long-term investors seeking capital preservation and consistent income.
Inflation Hedge and Income Consistency
Both REITs and direct property ownership offer inflation protection due to real estate’s intrinsic value and ability to generate rental income. However, direct ownership often provides a more reliable inflation hedge due to structured lease agreements with rent escalations linked to inflation indices. REITs, being market-driven, are more susceptible to investor sentiment and monetary policy shifts, which can introduce income volatility.
Conclusion
While both REITs and direct UK commercial property ownership provide exposure to real estate, their diversification benefits differ substantially. Listed REITs, due to their equity-like characteristics, do not provide the same level of uncorrelated returns as direct property holdings. By incorporating direct commercial property into a traditional portfolio of stocks and bonds, investors gain a more effective hedge against market fluctuations, reduced volatility, and a stable income source—making it the superior diversifier under Modern Portfolio Theory principles.
[1]“Volatility Transmission: Evidence from U.K. REIT & Stock Market” – This study examines the relationship between UK REITs and the stock market, providing insights into their correlation.
Patrick Ryan is a Principal and Co-founder at SIRE Capital Partners, working on Deal Origination and Asset Management.
Patrick has spent 20 years in the property sector in London.
His first foray into the sector was in 2003 when he co-founded a mezzanine finance business that focused on lending to property developers in and around London. Following this he headed up SIRE Properties, a healthcare focused asset management firm. Patrick has now co-founded SIRE Capital Partners that has expanded on his healthcare asset management focus to take in broader services to include brokerage and capital advisory.
