An Empirical Evaluation Of Normative Commercial Real Estate Swap Pricing

Despite the fact that commercial real estate makes up a large proportion of wealth, a functioning derivatives market exists since 2005 only, when swap contracts began to be traded in the UK in a notable amount. The liquidity of the markets is still far behind that of other established derivatives market. A reason for this may be that the pricing of the derivatives is not straightforward due to the special characteristics of the indices underlying the derivatives. Commercial real estate derivatives are primarily based on appraisal-based indices, which lag and smooth actual market developments. Geltner and Fisher (2007) show theoretically how to account for the lag and smoothing effects with regard to the equilibrium pricing of real estate swaps ñ the main type of derivative traded so far. The goal of this article is to examine empirically how important the adjustment terms necessary to obtain fair swap prices are. Differences between the US and the UK market are analyzed. The statistical characteristics of the time-varying lag adjustment will be explored and the adjustment for the permanent risk difference between actual real estate market and appraisal-based index returns will be calculated. We consider adjustments for swap maturities of one to five years. Finally, the development of actual commercial real estate swap prices in recent years shall be interpreted in the light of the empirical findings. The papers by Buttimer et al (1997), Bjˆrk and Clapham (2002) and Patel and Pereira (2008) examine theoretically the pricing of real estate swap contracts based on arbitrage analysis. Geltner and Fisher (2007), however, argue that the arbitrage pricing approach is problematic with regard to the analysis of swaps based on appraisal-based indices, because the index cannot be traded and may not always be valued such that it reflects the equilibrium expected return in the real estate market tracked by the index. Based on equilibrium pricing considerations, these authors show how to incorporate the lag and smoothing effects due to the use of appraisal-based indices. The contribution of this paper is to examine how important the adjustments necessary to obtain a fair swap price are empirically. This may yield valuable insights into fair commercial real estate swap pricing.