Errors in Variables, Links between Variables and Recovery of Volatility Information in Appraisal-Based Real Estate Return Indexes

The present article proposes a multivariate approach to unsmoothing appraisal-based real estate return indexes to recover the true market volatility information in real estate returns. It scrutinizes the role played by errors in variables, in conjunction with an analysis of other economic activities relevant to real estate returns, to exploit the functional relationship and the mechanism of interactions between real estate returns and these economic activities. Appraisal smoothing can therefore be detected and corrected properly and efficiently, without presuming a weakly efficient real estate market. The approach is then applied to U.K. real estate indexes as empirical examples. The results suggest a reasonable volatility in U.K. real estate investment that is close to reality. It is found that the volatility of the true market return on real estate is 1.5404–1.9282 times that of the return on the appraisal-based indexes, in contrast to figures of 2.4862–5.8720 produced by the fully unsmoothing procedure.