Importance of the innovation term for GARCH modelling of direct real estate returns

Abstract

ABSTRACT The autoregressive heteroscedastic effects of the conditional volatility processes of direct real estate (capital value) returns are subject to a broad range of econometrics. However, while many specifications have been utilised in the empirical design, the literature has commonly modelled the innovation term within the GARCH volatility processes of real estate capital values through a Gaussian normal distribution. This a priori assumption falls short of the data characteristics exhibited by capital value returns, implying that capital value returns cannot be adequately modelled without adapting to the innovation term distribution. Misspecification can underestimate risk and lead to the over-allocation of riskier assets. This study investigates the impact of the a priori assumption about the innovation terms applied to capital value returns, as well as their robustness, through a time-varying framework. The main findings are that misspecification and parameterisation occur when assuming the normality of the innovation term, and that the application of a priori assumptions of the innovation term beyond those of a normal, Student’s t, or generalised error distribution currently employed in the literature can increase the validity of volatility models when applied to capital value returns. The application of the Johnson – SU distribution yields the best overall performance.