The real estate sector is deeply intertwined with the overall economy. An increase in the real estate sector causes a corresponding increase in the GDP of a nation. Hence, the decrease is real estate activity also causes economic mayhem. It is for this reason that real estate needs to be monitored carefully by governments. By monitoring the real estate sector, the government can identify issues related to real estate before they become big or important. These issues can then be rectified with the use of fiscal and/or monetary policy. However, the issues need to be identified before such a resolution is reached. Hence, there is a need for a real estate price index.
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Ideally, such an index serves as the barometer for the entire market. However, construction of real estate indices is difficult because of very nature of the underlying asset. In this article, we will discuss some of the common difficulties that are faced during the creation of real estate price indices.
Common Problems Associated With Creation of a Real Estate Price Index
- Heterogeneity: Firstly, real estate is a very different asset class by nature. It cannot be compared with assets like stocks and bonds. All units of real estate are not fungible and homogenous. Instead, the nature of real estate transactions varies from one location to another. Hence the change in prices cannot be easily determined. This is the most challenging aspect when it comes to creating a real estate price index.
- Liquidity: Shares and bonds are regularly traded at all prices. Investors are provided information about the volume of shares and bonds that have been sold at a given price to give them an idea about the genuineness of the prices being quoted. This is not true of real estate. Whenever prices fall, sellers tend to hold on to their properties and postpone sales. For this reason, the negative sentiment and downfall of property values are never accurately reflected in a real estate price index.
- The frequency of Reporting: Unlike stocks and bonds, real estate does not have a short investment cycle. This means that the real estate values do not change on a real-time basis. Hence, it is not necessary that real estate indices should give a different quote every day. Most real estate indices only give a quote every three to six months. The change in real estate prices is not easily visible. One has to track the same index for a year or so to get the hang of the property market.
- Incorrect Valuation: Investors have no motive to incorrectly report the value of their shares and bonds. However, the same is not the case with property sales. The taxes on property sales can work out to a huge amount. Hence, to avoid paying such humungous taxes, it is not uncommon to simply report a lower price to the government. A lower price leads to a lower profit and hence lower taxes for the person involved. The balance amount is paid in cash and is often not accounted for. This misreporting distorts the whole picture. As a result, price indices do not give accurate information.
Methods of Creating a Real Estate Price Index
- The simplest way to create an index is to simply provide a weighted mean of all the property transactions that were reported during a given period. This method is not the most accurate. However, it is still followed in countries like Germany, Netherlands, Spain, and Australia. The major problem with this method is that it does not consider the fact that properties are heterogeneous. Since all the properties are mixed together the results are inaccurate at best. For instance, if only the values in urban areas continue to rise whereas the ones in rural areas are falling, the index could still show a positive trend!
- To get rid of the above-mentioned problem, many economists use the hedonic method. Under this method, the index does not show one single value. Instead, the property market of an entire nation is divided into several micro markets. This division could be on the basis of the urban-rural divide or on the basis of important cities. The idea is to create micro markets wherein properties with similar characteristics are aggregated. Also, the value of all the properties can be compared to a base year. For instance, if the value of all the properties in the year 2010 was considered as 100, the index will show the current value in 2018. If the value is 160, then there has been a 60% rise during the eight-year period. The problem with this method is that it requires extensive calculation. Several econometric formulas are used to arrive at the final index value. It is possible that the index may be skewed due to some vested interests. However, most of the times, the value depicted is fair and accurate. This method is used in Scandinavian countries, Switzerland, United Kingdom and even India. The National Housing Board Residex Index has been created on similar lines.