Empirical analysis of the average asset correlation for real estate investment trusts

The credit risk capital requirements within the current Basel II Accord are based on the asymptotic single risk factor (ASRF) approach. The asset correlation parameter, defined as an obligor's sensitivity to the ASRF, is a key driver within this approach, and its average values for different types of obligors are to be set by regulators. Specifically, for commercial real estate (CRE) lending, the average asset correlations are to be determined using formulas for either income-producing real estate or high-volatility commercial real estate. In this paper, the value of this parameter was empirically examined using portfolios of U.S. publicly-traded real estate investment trusts (REITs) as a proxy for CRE lending more generally. CRE lending as a whole was found to have the same calibrated average asset correlation as corporate lending, providing support for the recent U.S. regulatory decision to treat these two lending categories similarly for regulatory capital purposes. However, the calibrated values for CRE categories, such as multi-family residential or office lending, varied in important ways. The comparison of calibrated and regulatory values of the average asset correlations for these categories suggests that the current regulatory formulas generate parameter values that may be too high in most cases.