Dynamics of commercial real estate asset markets, return volatility and the investment horizon

The term structure of return volatility is estimated for both UK and US direct and securitised commercial real estate, using vector autoregressions. In a similar manner to the general stock market, returns of UK direct real estate and property shares, as well as US real estate investment trust returns, exhibit strong mean reversion. By contrast, US direct real estate returns show a considerable mean aversion effect over short investment horizons. This can be explained by the positive correlation between cash-flow and discount rate news, which can be interpreted as an under-reaction to cash-flow news. When estimating the return volatility of direct real estate markets, long-term investors need not be concerned about the choice of the parameter value used to unsmooth appraisal-based returns, because estimates of long-term volatility are almost unaffected by this choice.