Regime switching in yield structures and real estate investment

Abstract

The present study examines the structure of yields between broad asset classes (real estate, equities and government bonds) and the implications for portfolio allocation decisions and real estate investment. It is based on the premise that asset markets are integrated and that yield differentials trigger switching of funds among assets. Therefore, we investigate the claim that the yield ratios of indirect to direct real estate and of real estate to equities or bonds contain useful information for determining the likely direction of future real estate returns. A Markov switching model is used to identify different states in yield differentials. The Markov model identifies distinct regimes for the yield ratios of indirect to direct real estate, indirect real estate to equities and direct real estate to gilts. Trading rules are developed based on the filtered – real time – probabilities of the regime switching models. It is observed that the regime switching trading rules generate a superior risk‐return profile than simple buy‐and‐hold strategies. When transaction costs are allowed for, the Markov switching is still the superior strategy in two out of three portfolios.