A Measure of Fundamental Volatility in the Commercial Property Market

The low level of volatility observed in appraisal-based commercial property indices relative to other asset classes has been frequently noted and extensively commented on in the real estate finance literature. However, the volatility of such commercial property indices is only one source of information on the second moment of commercial property returns. The volatility of securitized property returns forms another potential source of information, though there is some uncertainty about how closely the volatility of securitized returns may match the volatility of the underlying asset. Each measure of volatility has a potential source of noise associated with it. This paper proposes a fundamental measure of volatility for the commercial property market by using a stochastic volatility model to filter out the signal in the different sources of volatility information. This allows for different measures of volatility to be decomposed into transitory noise and unobserved fundamental volatility. The suitability of such an approach and the properties of the underlying fundamental volatility series are analyzed using data from the U.K. property market.