Updated: Dec 30, 2021
By Cathy Zhang
Amidst the COVID-19 pandemic, the real estate market boom was one result of many. House prices increased, which made potential buyers weary of purchasing a home at this time. As we recall the real estate market crash in 2008, where prices dropped drastically, one important question to pose is, how exactly are home prices measured?
Housing is largely used as an indicator of wealth in society. Some may overlook the importance of a home, but it is crucial to understand how home values are measured to be able to understand the economy and trends in the real estate market. Housing prices have been correlated with inflation such as the Consumer Price Index(CPI) in the past, so it is even more relevant to delve further to understand this connecting piece of the economy.
In government legislation, the idea of “affordable housing” is frequently brought up. However, home prices matter because they decide what “affordable” really means. Furthermore, from an economic standpoint, the amount invested in a house affects consumer spending and saving.
It is difficult to measure home prices because of the heterogeneity of a home, which means that every home is different and these differences all matter in the eye of the buyer. In addition, houses are not sold as frequently as other liquid financial assets such as stocks, but most often occupied over a long period of time. Thus, there are three methods that economists use to measure home prices: hedonic, repeat sale, and average transaction cost.
Hedonic pricing determines price based on the attributes of the home, with each attribute having a fluctuating price of its own. Some of these attributes are internal such as the number of bedrooms and bathrooms, solar panels and the backyard, while others are external, such as the surrounding neighborhood or proximity to a school. For instance, the area I live in, on the border of West Falls Church and McLean, tends to have higher prices because of the school district and proximity to the metro to D.C. Thus, the advantages of this pricing method is that it takes into consideration internal and external factors that could affect the appeal of a property. In addition, it is relatively accurate and also flexible to be applied to other markets. However, a disadvantage is that this model does not take into consideration factors that consumers aren’t aware of at first glance. According to Investopedia, this could include contaminated water or disturbing construction next door.
2. Repeat Sale
The repeat sale method assesses the change in price of every repeated sale of the same one home. This method can not only provide information on a particular house, but it can also assess the real estate market as a whole, by calculating change in value over time. A significant advantage of this method is that it compares one house to itself over a period of time, rather than comparing houses with different characteristics. One drawback is that a house’s condition could deteriorate over time, which underestimates a home’s price if a renovation is needed. In addition, it does not account for homes that did not have repeated sales over the specific period of time.
3. Average transaction cost
The average transaction cost method calculates the mean of all observed transaction prices of a home. An advantage to this method is that it takes into account the sales of a home over an extended period of time from first transaction to last; however, a major disadvantage is that it does not control for heterogeneity amongst homes.
Recently, with the COVID-19 pandemic, measuring home prices is necessary to estimate inflation’s impact on the housing market. One conclusion is for sure, no matter the methodology: house prices have soared due to the demand and supply imbalance. As more and more move to the suburbs in a period of time where everything has become virtual, rent has increased in suburban areas. In the housing market, a shortage of homes is evident. Therefore, these three methodologies, hedonic, repeat sale, and average transaction cost allow us to achieve more accuracy when measuring prices of homes.