A Regime Switching Approach to Modeling Rental Prices of UK Real Estate Sectors

This paper uses regime-switching models of the threshold type to analyze the adjustment process of rental prices for three UK commercial real estate sectors over the period 1974 to 2008. The non-linear models outperform their linear counterparts in in-sample fit. Their out-of-sample forecasting ability is better whenever the corresponding linear models contain a significant amount of neglected non-linearity, which is the case in this study for the industrial sector. Switches into other regimes are triggered by past growth rates of rental prices exceeding a threshold level. For both the industrial and retail sectors, this occurs when the growth rates of rental prices push significantly above 2 or 5 percent per quarter, that is, in situations of strong excess demand. For the office sector, the switch occurs when rental rates are falling rapidly, that is, when the sector suffers from strong excess supply