An Empirical Evaluation of Normative Commercial Real Estate Swap Pricing

Despite the fact that commercial real estate comprises a large proportion of investable assets, a functioning derivatives market for private real estate has only existed since early 2005, when swap contracts began to be traded in the UK in significant amounts. Among other concerns about commercial real estate derivatives, the pricing issue is a major obstacle for the development of the market, due to the specific characteristics of appraisal-based indices used as the underlying of these derivatives. This article empirically evaluates a model of normative commercial real estate swap pricing, based on private real estate market indices, by estimating future appraisal-based index returns, and accounting for time-varying equilibrium risk premia. Differences between the US and the UK markets are analyzed. Finally, the development of actual commercial real estate swap prices in recent years is interpreted in the light of calculated 'fair' swap prices. Qualitatively, the estimated swap prices track actual market developments quite well, indicating that the modeled swap prices enhance our understanding of the pricing of commercial real estate swaps