The health of tenants not only is an important factor for commercial real estate landlords' profits; it is also closely tied to their stock prices. New research from Bank of America shows that the stocks of office real estate investment trusts are generally correlated to the stocks of financial-related companies, which tend to make up a good portion of their tenant bases. In addition, retail REITs, which own malls and shopping centers, are well correlated to retailer stocks, according to the report from analyst Christy McElroy. Over a three-year and five-year period, the correlation between office REITs and the S&P IBK/Brokerage and Financial indices is around 0.95. In measuring correlation, a reading of 1.0 suggests the two sectors' stock prices move in the same direction at all times. Thus, the 0.95 reading means that office REITs and financial stocks are nearly always moving in lockstep fashion. The caveat, McElroy says, is that the year-to-date correlations have been skewed by the sharp rise in office REIT prices earlier this year. But during any time interval over the past 10 years, the correlation between office REITs and financial stocks has been 0.84 to 0.96, the analyst says. How is this information useful to investors? Well, for one, it shows how owning stocks in both sectors reduces diversification. It also suggests that investors can develop long/short trading strategies by using stocks and exchange-traded funds to hedge against losses.
Although Bank of America is not recommending any particular trading strategies, several are easy to imagine. For example, investors could buy office landlord Vornado Realty Trust ( VNO), while also shorting the Financial Select Sector SPDR ( XLF) ETF. Year to date, Vornado has fallen about 5%, while the financial sector ETF is down about 3%. If you owned Vornado, shorting the ETF would have protected against some losses. Retail REITs and retailer stocks are also well correlated over thee-year and five-year periods. Mall REIT stocks have a 0.86 to 0.96 correlation with the S&P Retail index over this time period. To play this strategy, investors could buy the country's largest mall owner, Simon Property Group ( SPG), while shorting a retailer ETF such as the SPDR S&P Retail ( XRT) ETF. So far this year, Simon Property Group is up about 5% and this ETF is flat. Other REIT sectors didn't show as much correlation. Health care REITs show no significant correlation with either health care, pharmaceutical, or biotechnology stocks, the report said. McElroy found a correlation between industrial REITs and manufacturing stocks over a five-year interval, but little correlation over other time periods she analyzed. Bank of America also found that apartment and self-storage REITs have strong correlations with each other (around 0.96 to 0.98 historically), but neither has meaningful correlations with homebuilder stocks or the Philadelphia Housing Index.