The stability of the co‐movements between real estate returns in the UK

The usefulness of ex‐post data as a proxy for ex‐ante returns in the portfolio problem rests on the stability of the co‐movement between returns. Yet despite its importance, this issue has not received sufficient examination in the financial literature, particularly in the direct real estate market. This study aims to address this issue.

To examine the temporal stability of covariance and correlation matrices and individual correlation coefficients this paper uses the Box M tests and the methodology of Shaked using monthly real estate data in the UK over the period 1987 to 2002 and four investment horizons.

The Box M tests reveal that the covariance and correlation matrices both display temporal instability. This suggests that the returns between real estate returns are unstable over time and so provide poor estimates in the ex‐ante modelling process. The analysis also indicates that the covariance matrices are less stable than the corresponding correlation matrices. Nonetheless, when we tested the stability of individual correlation coefficients using the methodology of Shaked we find that stability increases consistently and substantially with the lengthening of the investment horizon and holding period.

Thus, for all practical purposes the pair‐wise correlation between real estate returns can be considered nearly stationary in the long run. This implies that investors can use ex‐post data as a proxy for ex‐ante data in portfolio models especially if longer investment horizons are used to estimate the parameters.

This study is the first to examine temporal co‐movements between UK real estate returns in a portfolio context over different investment horizons.