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Construction and Application of
Property Price Indices

The importance of house prices to households, real estate developers, banks and
policy-makers cannot be overemphasised. House price changes affect consumer
spending and business investment patterns, which in turn affect the wider macro
economy and the entire business cycle. Measuring and understanding house
prices is therefore essential to a functioning economy, but researchers continue to
disagree on the best methodological approach for constructing real estate indices.
This book argues the need for more accurate house price indices, outlines the
various methods used to construct indices and discusses the existing house price
indices around the globe. It shows how the raw data of property transactions can
be prepared for the purpose of constructing indices, discusses various applications
of property price indices and empirically demonstrates how the index numbers
can be used to model the supply of new houses and to estimate the price elasticity
of supply.
Essential reading for economists, real estate professionals and researchers, and
policy-makers.

Anthony Owusu-Ansah (PhD) is a Senior Lecturer and Coordinator of Graduate

Programmes at the Business School of the Ghana Institute of Management and
Public Administration (GIMPA), Accra. He has published extensively in the
areas of house price index construction, housing market dynamics, hedonic
modelling and the role of real estate in portfolio management. He is a professional
member of the Ghana Institution of Surveyors and an Associate of the British
Higher Education Academy.
Routledge Studies in International Real Estate

The Routledge Studies in International Real Estate series presents a forum for the
presentation of academic research into international real estate issues. Books in
the series are broad in their conceptual scope and reflect an inter-disciplinary
approach to Real Estate as an academic discipline.

Oiling the Urban Economy

Land, Labour, Capital, and the State in Sekondi-Takoradi, Ghana
Franklin Obeng-Odoom

Real Estate, Construction and Economic Development in Emerging Market

Economies
Edited by Raymond T. Abdulai, Franklin Obeng-Odoom, Edward Ochieng and
Vida Maliene

Econometric Analyses of International Housing Markets

Rita Li and Kwong Wing Chau

Sustainable Communities and Urban Housing

A Comparative European Perspective
Montserrat Pareja Eastaway and Nessa Winston

Regulating Information Asymmetry in the Residential Real Estate Market

The Hong Kong Experience
Devin Lin

Delhi’s Changing Built Environment

Piyush Tiwari and Jyoti Rao

Housing Policy, Wellbeing and Social Development in Asia

Edited by Rebecca L. H. Chiu and Seong-Kyu Ha

Construction and Application of Property Price Indices

Anthony Owusu-Ansah

Residential Satisfaction and Housing Policy Evolution

Clinton Aigbavboa and Wellington Thwala
Construction and
Application of
Property Price Indices

Anthony Owusu-Ansah
First published 2018
by Routledge
2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN
and by Routledge
711 Third Avenue, New York, NY 10017
Routledge is an imprint of the Taylor & Francis Group, an informa business
© 2018 Anthony Owusu-Ansah
The right of Anthony Owusu-Ansah to be identified as author of this work
has been asserted by him in accordance with sections 77 and 78 of the
Copyright, Designs and Patents Act 1988.
All rights reserved. No part of this book may be reprinted or reproduced or
utilised in any form or by any electronic, mechanical, or other means, now
known or hereafter invented, including photocopying and recording, or in
any information storage or retrieval system, without permission in writing
from the publishers.
Trademark notice: Product or corporate names may be trademarks or registered
trademarks, and are used only for identification and explanation without
intent to infringe.
British Library Cataloguing-in-Publication Data
A catalogue record for this book is available from the British Library
Library of Congress Cataloging-in-Publication Data
Names: Owusu-Ansah, Anthony, author.
Title: Construction and application of property price indices / Anthony
Owusu-Ansah.
Description: Abingdon, Oxon ; New York, NY : Routledge, 2018. |
Series: Routledge studies in international real estate | Includes
bibliographical references and indexes.
Identifiers: LCCN 2018006273 | ISBN 9781138104709 (hardback : alk.
paper) | ISBN 9781315102085 (ebook)
Subjects: LCSH: Price indexes—Methodology. | Housing—Prices—
Statistics. | Real property—Prices—Statistics. | Real estate business.
Classification: LCC HB225 .O98 2018 | DDC 333.33/823—dc23
LC record available at https://lccn.loc.gov/2018006273

ISBN: 978-1-138-10470-9 (hbk)

ISBN: 978-1-315-10208-5 (ebk)

Typeset in Goudy
by Keystroke, Neville Lodge, Tettenhall, Wolverhampton
Contents

Acknowledgementsvii

1 Introduction 1

2 Property valuation and appraisal indices 7

3 A global tour of transaction property price indices 16

4 The theory of hedonic pricing modelling 33

5 Property price index construction methods 63

6 The study area and the data 84

7 Empirical demonstration of property price index construction 116

8 Applications of property price indices 142

9 The last word 182

References 192
Index 205
Acknowledgements

This book is the product of research begun in September 2009 at the University
of Aberdeen in the UK. I have received a lot of feedback on earlier drafts from
many great academics and industry players. I wish to single out and acknowledge
the staff at the Centre for Real Estate Research at the University of Aberdeen,
especially Dr Rainer Schulz, Professor Deborah Roberts, Professor Norman
Hutchison and Professor Bryan McGregor for the guidance, encouragement,
feedback and negotiating the data access during the research process. To them,
I am most grateful.
I also wish to thank the Aberdeen Solicitors Property Centre for providing
their housing transaction data for the research and also to all the other data
providers. I also wish to thank Professor Stanley McGreal (University of Ulster,
UK), Professor Mats Wilhelmsson (Royal Institute of Technology, Sweden),
Dr Raymond Abdulai (University of Newcastle, UK) Professor Samuel Azasu
(University of Witwatersrand, South Africa), Dr Franklin Obeng-Odoom
(University of Technology Sydney, Australia), Dr Steven Devaney (University of
Reading, UK), Professor Paul Asabere (Temple University, USA) and Dr Cynthia
Holmes (Ryerson University, Canada) for critical comments which have helped
to strengthen this book.
I thank my family and very close friends for the encouragement and different
suggestions during the research process – especially Mrs Amma Serwah Owusu-
Ansah, Francis Owusu-Ansah, Hillary Owusu-Ansah, Mr Francis Ohemen,
Dr Eric Yeboah, Dr Kenneth Soyeh, Dr Wilfred Anim-Odame, Mr Joseph Abbey
and all the colleagues and students at the Ghana Institute of Management and
Public Administration, Accra.
Finally, I thank all the anonymous reviewers and editors of Journal of Property
Research, Property Management, the International Journal of Housing Markets and
Analysis, and Routledge for the useful comments and suggestions during earlier
versions of chapters of this book.
1 Introduction

The setting
Real estate is so important a subject that it cannot be left out in any serious
macroeconomic deliberation and the collective quest for wealth creation and
economic development. This is true whether in the advanced or developing world.
Land, for example, is a primary commodity that provides space for human and
economic activities. Thus, for many people around the world it is a very strate-
gic economic asset. It is, therefore, not surprising that in many countries in the
developing world, landed property accounts for about 50% to 75% of the national
wealth (Bell, 2006).
Real estate can be broadly grouped into residential real estate and non-
residential real estate (Brueggeman and Fisher, 2001). Residential real estate
includes flats, single-family houses and multi-family properties such as apartment
blocks. This real estate provides accommodation for households and is often
called “housing”. The non-residential real estate includes commercial real estate
such as hotels, factories, offices, warehouses and retail buildings, agricultural real
estate, land and corporate real estate like hospitals and universities. The focus of
this book is largely on residential real estate or housing.
Housing forms a major component of the real estate market. In the UK, the
most valuable asset of the nation’s wealth is residential real estate with a total
value of £6.8 trillion in January 2017, representing about 3.7 times the country’s
GDP (Financial Times, 2017). According to the statistics, the figure is nearly half
the value of all companies on the London Stock Exchange, with London and the
South East accounting for almost half of the total value. Various studies, including
Green (1997) and Coulson and Kim (2000), have established the effects of
housing investment on a country’s economic growth. These studies note that
residential real estate investment for instance may stimulate GDP growth more
than other types of investment because a lot of jobs, both direct and indirect, are
created by the sector. Real estate has played a major role in shaping the business
cycles of countries like the USA, Britain, New Zealand, Australia and Canada
(Hale, 2008).
Furthermore, the price of real estate has an impact on the net wealth of people
who own it. In Britain, home-ownership has grown rapidly between 1971 and
2 Introduction
2010 from about 49% to 68.5% (ONS, 2011). Since about 75% of house purchases
in the UK are financed with a mortgage loan, and the average mortgage repayment
accounts for almost 19% of the average household income in the early 2000s
(ONS, 2004), a change in house price can affect the value of home-owner wealth
and consumption expenditure. As Tsatsaronis and Zhu (2004) observe, since the
behaviour of house prices affects individual expenditure, the aggregate expend-
iture is also affected. House price changes affect consumer spending and business
investment patterns through the wealth effect, which in turn affects the wider
macro economy and the entire business cycle dynamics. The importance of
accurate information on house prices to households, real estate developers, banks
and policy-makers therefore cannot be over-emphasised.
Measuring of house prices is, however, not easy. This is because real estate in
general has a set of unique characteristics with regard to location, structural
composition as well as neighbourhood and environmental quality. That is, unlike
the stock market for instance, the real estate market is highly heterogeneous
in the sense that there are different market segments and property types and so no
two properties can be considered as being the same. Two residential properties
can be similar with regard to some of the physical characteristics but they can
never be the same because no two properties can be located at the same place.
Also, there is no central location or trading place where properties are transacted,
and there are also high transaction costs associated with the selling or buying of
a real estate. The heterogeneity that exists in the real estate market, the lack of a
central trading place and the high transaction costs have made gathering of
information on the property market difficult.
Transaction data in the property market is very difficult to come by. Commercial
real estates for instance are hardly sold on the market. Renting is therefore the
common way of transferring commercial property from one person to the other.
As a result of this, there is insufficient information available on transaction prices
of commercial properties. The construction of price indices for commercial pro-
perties therefore is largely based on appraisals. Examples of such commercially
available indices include the NCREIF (National Council of Real Estate Investment
Fiduciaries) Index, JLW (Jones Lang Wootton ) and the IPD (Investment Property
Databank). These and other available commercial indices are mentioned in
Chapter 2. Appraisal data is also mostly used to construct indices for residential
properties in emerging markets. In such housing markets, property transactions are
not frequent and the properties that are transacted are mostly done in secret and
so transaction databases rarely exist in such markets. Most of the housing market
analysis that involves an examination of market values or prices use the appraisal
data (Owusu-Ansah, 2012a). In such housing markets and all commercial property
markets, the work of the appraisers are very important in order to obtain reliable
results. The appraiser’s task is to assess the market value of the properties at a given
point in time using any of the commonly accepted methods of valuation. These
methods are discussed in Chapter 2.
In situations where raw data about real estate transactions exists, it is normally
difficult to understand and easily make use of such data because of the real estate
 Introduction 3
market heterogeneity. One way in which raw real estate data can be meaning-
ful and useful is to transform the data so as to construct property price indices
(showing price movements over time). However, real estate, like other capital
assets, is a composite asset and so it is sold wholly as one unit. When the factors
that cause the changes in real estate prices are uncovered, it helps to understand
house price changes. The factors that may cause changes in real estate prices
may be due to shifts in the relationships between demand and supply; and may
also be caused by differences in dwelling characteristics and/or differences in or
quality of locational and neighbourhood attributes of the properties sold. It is
therefore necessary to remove the effect of the different and mixed physical and
locational attributes on real estate prices and to efficiently measure the variation
in real estate prices caused by inflation on a standardised basis. In the UK, the
main sources of house price information are the Halifax, Nationwide, HM Land
Registry and the Council of Mortgage Lenders (CML). Each provides price
indices of the private housing market at regional and national levels. The HM
Land Registry and the CML indices are based on the repeat-sales and mean prices
of the transactions respectively. Therefore, the CML price information is likely
to be influenced by the differences in physical characteristics and locational
attributes and so they are not constant-quality. Both the Nationwide and the
Halifax indices are constructed using the hedonic regression technique but their
indices do not exist at local levels, only at national and the twelve regional levels,
including Scotland. The existing house price indices that exist in the UK and
some other international markets are discussed and compared in Chapter 2.
In terms of real estate price index construction, there are three main quality-
controlled index construction approaches: the hedonic, repeat-sales and the hybrid,
which is a combination of the first two approaches. With the hedonic technique,
the price of the property is regressed on the characteristics of the property and may
be applied on a period by period basis or estimated on pooled transaction data with
time dummies as additional regressors. In each case, however, objections have been
raised as to the difficulties involved in identifying all the relevant price influences
and the correct functional form (Case and Quigley, 1991; Shiller, 1993).
Due to the difficulty involved in identifying and gathering all the physical and
locational characteristics, the repeat-sales method standardises the characteristics
of the properties with reference only to themselves, by confining the analysis to
properties which have been sold at least twice (Bailey et al., 1963). The method
is however criticised as it discards all the single-sale transactions, thereby wasting
a lot of transaction data. Thus, the fraction of properties which are repeat-sales is
likely to be small in any market (Palmquist, 1982; Mark and Goldberg, 1984;
Case, 1986; Case and Shiller, 1987, 1989).
The hybrid method utilises the desirable features of both the hedonic and the
repeat-sales techniques to estimate real estate price indices. It uses all available
information on property sales, whether single or repeat transactions, and also
capitalises on the added precision when multiple transactions exist, by comparing
transaction prices for the same properties. The method is therefore used to
estimate the real estate prices for a standardised unit by combining data from
4 Introduction
single transactions where one sale is observed; multiple where the physical and
locational characteristics are the same; and multiple transactions where the
physical and locational characteristics of the property have changed between
sales. The hybrid method has however been rarely used in practice. This book
discusses these methods in detail and empirically uses transaction data to
demonstrate how index numbers can be produced using all these methods.
The literature has reached no firm conclusion as to which index construction
method performs best in terms of accuracy (see for example, Case and Quigley,
1991; Quigley, 1995; Haurin and Hendershott, 1991; Thibodeau, 1997). Case
et al. (1991), for instance, find repeat-sales indices increase more slowly than
those constructed using other methods. They also do not find any clear efficiency
gains from using the hybrid method. This is in contrast with Case and Quigley
(1991) who find the hybrid method to be more reliable. This inconsistency
may be due to the way in which the index accuracies are measured. An average
index is usually used as a benchmark index against which the index from the
other methods are measured. This is clearly problematic since the average
index does not control for property heterogeneity. There is therefore the need for
further empirical studies on the examination of index accuracy. This book
provides an alternative way of measuring index accuracy, and these various
methods have been empirically compared with respect to accuracy in different
situations.
Beyond the issues of index construction technique selection and the need to
monitor real estate prices at the local level is the pooling of data across time in
analysing trends and volatilities in prices. Most studies in the literature have
arbitrarily pooled data into broader representations of time to estimate indices.
The perception is that pooling data helps overcome the problem of small sample
size, a common problem encountered in studies using real estate transaction data.
In doing this, however, they implicitly assume that the pooled sample will produce
index numbers that are statistically equivalent to those that would have been
obtained from their constituent sub-samples. Since factors such as buyer
preferences and supply conditions play a crucial role in determining real estate
prices, and these may vary across time, it is necessary to test if pooling of data
alters predictive performance. This book contributes by testing the temporal
aggregation effect.
The analysis of real estate markets can be at national, regional or local level
depending on the data required. If it is at the macro level, then crude data aggre-
gates might be sufficient. But an index aggregated from reliable local information
would be better. Reliable local information is necessary when the level of analysis
is local (Hwang and Quigley, 2006; Maclennan, 1977). In examining the British
housing market for instance, Meen (1999) notes that the housing market in the
UK may be best described as a series of different local markets that are interlinked
rather than characterising it as a single national market. One of the important
features of real estate price indices is that they should be local in terms of spatial
coverage (Costello and Watkins, 2002). Indeed, making assumptions based on
the aggregate nature and behaviour of markets when constructing house price
 Introduction 5
indices at the neighbourhood level may make the resulting index unreliable
(Munro and Maclennan, 1986). The book shows why real estate market analysis
should be confined to the local level instead of using an aggregated market to
analyse the various local markets.
In the literature, constant-quality house price indices have been applied in
several areas. These areas include asset pricing, empirical tests of housing market
efficiency, hedging mechanisms for house price volatility, estimating real estate
derivatives and home equity insurance, estimating the relationship between
house prices and housing demand, as well as modelling the supply of housing.
This book demonstrates how index numbers can be applied to estimate housing
supply and the price elasticity of supply.
Based on the discussions above, the aim of this book is to demonstrate how
to construct and apply property price indices so as to benefit academics, practi-
tioners and policy makers. In order to accomplish this aim, three objectives are
pursued and set out as follows: (i) to establish the state of current knowledge on house
price index construction methods and identify areas where further knowledge or research
is required; (ii) to apply the different methods to the same dataset, empirically examine
the accuracy of the various methods and examine the effect of aggregating observations
on house prices across time; (iii) to use the house price index series to learn more about
the supply side of the Aberdeen housing market.

Structure of the book

Chapter 2 discusses the various traditional property valuation methods. These
include the comparison sales approach, the replacement cost method, the income
method, the profits method and the development or residual method. Some of the
existing appraisal based indices around the world are presented in the chapter.
These include the NCREIF index, JLW and the IPD.
Chapter 3 provides a global tour of the existing transaction-based property
price indices. The chapter begins by discussing the meaning and importance of
property price indices. The attributes which determine the quality of a property
price index are also discussed in this chapter. Some of the indices existing around
the globe are discussed. The scope, methodology and the level of index con-
struction are all discussed. Notably, the Halifax and Nationwide indices produced
for the UK housing market are discussed as well as the S&P/Case-Shiller indices
in the USA.
Chapter 4 discusses the hedonic pricing theory. All the property price index
construction methods directly or indirectly draw inspiration from this theory. The
chapter begins with an overview of the hedonic theory. It also identifies the var-
ious property characteristics that affect that price of the property and how to
include them during the modelling processes. Next, the various functional forms
and how to select a functional form to fit a hedonic model are discussed. Finally,
the main sources of hedonic problems and how to control or deal with them
during the modelling process are identified and discussed.
Chapter 5 discusses the various property price index construction methods.
These methods are the average method, the hedonic method, the repeat-sales
6 Introduction
method and the hybrid method. The advantages and disadvantages of these
methods and how the methods have been compared in the literature are all
discussed. The issue of temporal aggregation (i.e. pooling data across time) and
how that can affect the index numbers is also discussed.
Chapter 6 introduces, prepares and describes the data used for demonstrating
how property price index construction is done. The source of the data and the raw
dataset and its limitations are all discussed. The data cleaning exercise is described
in this chapter. By doing this, some variables are dropped and new variables are
generated to aid the analyses, and the final dataset is presented and described.
Chapter 7 begins with the empirical analyses. Five models from the three main
house price index construction methods are implemented at various levels
of temporal aggregation. The models are the explicit time variable (ETV) hedo-
nic model, strictly cross-sectional (SCS) hedonic model, ordinary repeat-sales
(ORS) model, weighted repeat-sales (WRS) model and the Quigley’s hybrid
(Q-hybrid) model. The implicit prices of the housing and locational attributes are
tested to find out if they are constant over time. The out of sample technique is
used in this chapter to measure the mean squared error (MSE) of the various
index construction models to examine the accuracy of the different index models.
The effect of temporal aggregation on house price indices is also examined.
Chapter 8, the penultimate chapter, focuses on an application of house price
indices. The chapter uses constant-quality house price indices for the Aberdeen
City district together with other variables to examine the determinants of housing
construction and to estimate the price elasticity of supply for the Aberdeen local
housing market using different model specifications. The chapter compares the
price elasticities of supply for the Aberdeen local market with the price elasticities
of supply for other local areas in the UK and also highlights the need for housing
market analysis to be confined to local or district levels.
Chapter 9 summarises and concludes, providing several conclusions that are
drawn from the research. The main findings are presented in relation to the
research objectives. This is followed by policy implications and contributions
the research makes to knowledge. Finally, limitations of the research as well as the
potential areas for future research are provided to conclude the book.
2 Property valuation and
appraisal indices

Introduction
The measurement of house prices is not easy due to the fact that real estate in
general has a set of unique characteristics with regard to location, structural
composition as well as neighbourhood and environmental quality. Two residential
properties can be similar with regard to some of the physical characteristics but
they can never be the same because no two properties can be located at the same
place. Also, there is no central location or trading place where properties are
transacted, and there are also high transaction costs associated with the selling or
buying of real estate. The heterogeneity that exists in the real estate market, the
lack of a central trading place and the high transaction costs have made gathering
of information in the property market difficult. Real estate transaction data is very
difficult to come by in order to measure house price movements accurately.
Commercial real estates for instance are hardly sold in the market. Renting is
therefore the common way of transferring commercial property from one person
to the other. As a result of this, there is insufficient information available on the
transaction prices of commercial properties. The construction of price indices for
commercial properties therefore is largely based on appraisals. Examples of such
commercially available indices include the NCREIF Index, JLW and the IPD.
These and other available commercial indices are discussed in this chapter.
Appraisal data is also mostly used to construct indices for residential properties in
emerging markets. In such housing markets, property transactions are not frequent
and the properties that are transacted are mostly done in secret and so transaction
databases rarely exist in such markets. Most of the housing market analysis that
involves an examination of market values or prices use the appraisal data. In such
housing markets and all commercial property markets, the work of the appraisers
is very important in order to obtain reliable results. The appraiser’s task is to assess
the market value of the properties at a given point in time using any of the
commonly accepted methods of valuation. In the second section of the chapter,
the various traditional property valuation methods such as the comparisons sales
approach, the replacement cost method, the income method, the profits method
and the development or residual method are discussed. The third section also
presents some of the existing appraisal-based indices around the world and the
fourth section concludes the chapter.
8 Property valuation and appraisal indices
Property valuation types
Valuation is defined as the process of ascribing values to land and landed proper-
ties. The basis of valuation is mostly the open market value. The International
Valuation Standards Council (2017) defines the market value as:

The estimated amount of money for which an asset should exchange on the date of
valuation between a willing buyer and a willing seller in an arm’s-length transaction
after proper marketing wherein the parties had each acted knowledgeably, prudently
and without compulsion

That is, the price at which an interest in real property might reasonably be
expected to be sold by private treaty assuming:

i a willing seller and a willing buyer, neither of them being under any com-
pulsion to participate in the market;
ii a reasonable period within which to negotiate the sale, taking into account
the nature of the subject property and the state of the market;
iii both parties are well informed or well advised about what they consider their
own best interest;
iv values would remain reasonably stable throughout the period;
v no account is taken of an additional bid by a special purchaser;
vi that the property is put to its highest and best use; and
vii that the transaction is based on cash or cash equivalent consideration.

The estimation of the market value can be conducted using different methods.
The five traditional methods that are known are the (i) comparison sales approach,
(ii) depreciated cost approach, (iii) income approach, (iv) profits method and
(v) development or residual method.

The sales comparison approach

The sales comparison approach (SCA) is the process in which the market value
is estimated by analysing the market for similar properties and comparing these
properties to the subject property. Analysis focuses on similarities and differences,
which affect the property value.

Value of the property = prices for comparable and competitive properties ±

adjustments for difference.

The SCA relies on the principle of substitution. This is because a property is

worth the same as another property with similar utility. The method is applied
when the property or similar ones appear frequently on the market.
 Property valuation and appraisal indices 9
Procedure
i Find comparable properties: The SCA relies heavily on comparisons. The
accuracy of the method therefore is a direct function of the comparability
of the properties being used in comparing prices. The comparables must
therefore be the subject matter of recent transactions. There should also be
enough comparables to improve the quality of the method.
ii Identify characteristics of value of the subject property and comparables: There
are two sets of characteristics that the valuer must consider – property
characteristics and non-property characteristics. The property characteristics
are the physical and the locational elements of the properties such as the size
of the property or plot, the constructed space of the two properties, the type
and quality of the construction as well as the location of the properties. As
much as possible, the subject property and the comparables must be similar
with regards to the characteristics above. The non-property characteristics
must also be considered and these include the date of sale, unusual conditions
to sale like the relation between the parties and the type of interest
encumbered on the property, whether freehold or leasehold.
iii Make adjustments to reflect the differences between the subject properties and the
comparables: The purpose of the adjustments is to estimate the price at which
the comparable property would be sold if it were the same as the subject
property. Adjustments are used when the subject property and comparable
sales have differences in the following:
• locations;
• physical characteristics of the property, such as size, age, quality of
construction, conditions of the property, attractiveness etc;
• lease contracts and quality of tenants;
• external factors, given by market etc.
Here is an example of the adjustment: If the subject property has a better
location than comparable sales and other factors are equal, then it should
have a higher value than the comparable sales. If this is the case, appraisers
adjust the price of the comparable sales upwards to estimate the market value
of the subject property.
iv Do a collation of the results to get a value for the subject property.

The comparisons sales approach is useful so far as there are more recent com-
parables and appropriate adjustments are made to the comparables to reflect the
subject property. That is, there is some element of subjectivity which makes
the role of the valuer very important.

The depreciated cost approach

The cost method proposes that the value of a property is approximately the cost
of replacing the improvement, less accrued depreciation plus site value. Using this
10 Property valuation and appraisal indices
method, the market value is estimated assuming that the rational investor will
not pay more than the cost of replacing the property with the one which is equally
productive on a comparable site.

Value of the property = land value + the replacement cost of the building
– depreciation

Like the sales comparison approach, the method is premised on the principle of
substitution because it is presumed that a buyer will not pay more for a site than
the amount it will cost to make improvements on an equal plot.
Where the land value is estimated by means of the sales comparison approach;
replacement cost is a composition of the property size and the replacement cost
per unit of the size; depreciation is the negative difference between the value of
the subject property and the value of a new property.

Procedure
i Estimate the replacement cost: The replacement cost is the cost of replacing
the existing improvement with another one offering equal utility. There are
four methods to assess the replacement cost. These are: the (a) unit-in-place
method. With this method, the structure is broken down into its components
and the cost of each component is established. Examples are the superstructure,
substructure etc. The estimated cost must be the current cost; (b) quantity
survey method. This method is more detailed than the first one. Instead of
units, the structure is broken down into components which are analysed on
their own. Because of the details, there is a possibility of ending up with a
higher figure than using the first method; (c) comparative unit method. This
is a simpler version of unit-in-place method. This method involves looking
at the estimated cost of the entire building. After arriving at the cost, it is
divided by the floor space to obtain the cost per square metre; (d) construction
cost services method. This method involves a ready reckoning of costs on
construction of property. It is a list that gives an idea as to the amount that
will be needed to construct a building.
ii Assess depreciation: Depreciation is a measure of the loss of utility due to the
present condition of the improvements as compared to a completely new one.
Depreciation therefore represents the reduction in value of the improvements
due to physical, functional and economic features. The physical depreciation
is the loss of value due to wear and tear and the effect of other elements over
time. Every manmade improvement suffers from being used up. This is called
physical depreciation. Physical depreciation is curable when the curable cost
is equal to or less than the value added to the property. The functional
depreciation or obsolescence is the loss attributable to the improvements’
inability to give similarly efficient utility that a new improvement with
possible new design will give. Functional obsolescence reflects taste and type
 Property valuation and appraisal indices 11
of design. The economic depreciation, also known as external or locational
depreciation, results indirectly from the negative environmental factors or
conditions in the neighbourhood. It is a loss of utility from the negative
environmental conditions.
iii Find the depreciated replacement cost: This is arrived at by deducting the
depreciation (ii) from the estimated replacement cost (i).
iv Estimate site value: We apply the market data approach to estimate the value
of the land per se.
v Estimate property value: Add the depreciated replacement cost (iii) to the
estimated site value (iv) to get the estimated property value.

The cost method is applied in the valuation of properties which scarcely change
hands in the open market. This includes specialised properties such as schools,
hospitals, libraries, community centres, churches etc. It is used where the subject
property is relatively new and authentic data relating to cost of construction are
available. In using the method, however, we assume that cost is equal to value.
Cost may be approximated to value but most of the time it is not equal to value,
and this is one of the greatest weaknesses of this method.

The income approach

The income method estimates the market value by taking into consideration
future incomes from the property. The approach normally requires a discounted
cash flow analysis, but in practice simplified models are used. An appraiser
estimates the market rent for the property, the impact of lease terms, and expenses
for the property. One of the methods is to divide net operating income of the first
year by the capitalisation rate.

Value of the property = Net Operating Income (year 1) / Required return –

growth rate + depreciation rate

The principle underlying this method is that the market value of the property
is equivalent to the price the purchaser will pay. Therefore, the capital value of
the property reflects the income generated by the property and the rights to the
income generated by the property. Availability of accurate information on the net
income and the required rate is a key determinant of the correctness of the
method.

The profits method

This method is also known as the accounts method. The profits method proceeds
by establishing the profit that the hypothetical tenant/operator will make out
of the premises in order to determine what he is likely to give to enable him have
the opportunity of making the profit. In other words, the tenant will pay for a
12 Property valuation and appraisal indices
place provided the business on the premises generates some profits from which
a reasonable portion will be paid as rent. The principle here is that capital value
is related to the turnover or volume of trade from the business that is being
operated on the premises which forms the subject of valuation.

Procedure
  i Estimate the gross receipts or earnings from the business being operated on
the premises. In doing this, care should be taken to ensure that only earnings
or revenues related to the business are considered.
  ii Estimate the working expenses incidental to the earnings. That is only
expenses that are directly related to the business are considered.
iii Work out the divisible balance. This is difference between the gross receipts
and the working expenses. The divisible balance comprises the interest on
capital which the operator uses to run the business and the remuneration for
the tenant operator for the risk incurred in running the enterprise.
iv Establish the gross rental value. To arrive at this, deduct from the divisible
balance an amount representing the interest on the capital and remuneration.
v Estimate the net rental value by deducting items like rates, tax etc.
vi Capitalise the net rental value at the appropriate rate to get the capital value
of the premises.

The method is an indirect approach to the valuation. It works best when the
business records are available to facilitate accurate estimates. Where a particular
operator has special skills that enable him to have extra profit, then this should
be ignored. This is because we look at a situation where an average person is
operating under reasonable conditions and make reasonable profits.

The development or residual method

This method is used solely in the valuation of development properties. A
development property is that property which is capable of giving higher income
if capital is spent on its development, refurbishment or redevelopment, or
change in user or both. The value of the property therefore is said to be latent.
The development or change of user may however be subject to planning
permission.
The principle is that the prospective purchaser will pay for such development
property the equivalent of the surplus after he has met his costs out of the proceeds
from the sale of the completed development. The costs may include the cost of
construction, cost of finance, allowance, risks etc.

Procedure
  i Conduct a preliminary study: This is to determine the type of development
best suited for the land. Availability for planning permission for that use must
 Property valuation and appraisal indices 13
also be considered. Again, the appraiser must estimate the period of time for
the development.
ii Estimate the market value of the property. That is, the capital value of the
increased incomes that goes with the proposed user.
iii Estimate all costs which include cost of construction, cost of finance,
development profit etc.
iv Estimate the value of the property by deducting the total costs from the
proceeds of the sale of the property.

All the methods mentioned above will give different values to the appraiser.
After that the appraiser has to make a decision about the final figure. This process
is called a reconciliation of value estimates. Boykin and Ring (1986) give the
following definition:

Reconciliation is the careful weighing of the initial value results on the basis of
accuracy and completeness of data and in light of market conditions that prevail on
the date of the appraisal.

The usage of one or another valuation approach depends on the available data
and the type of valued property. If there is a significant difference between the
values, the models should be checked for accuracy.

Existing appraisal indices around the world

The appraisal-based indices mostly exist for commercial properties since the
amount of information available on transaction prices in the commercial property
market is insufficient, as already discussed in Chapter 1. The appraisal indices are
constructed as an average of the current appraised values of the properties at each
period of time in which the index is reported. Like the transaction-based indices,
the appraisal-based indices can be constructed for national, regional or local
markets, and for a particular property types.
It is not possible to consider the whole market when constructing an index,
whether appraisal-based index or transaction-based index. Thus, appraisal-based
indices rely on a sample of properties. The main task here is to collect as much
representative data for the sample as possible. As the properties are transacted on
an irregular basis, their values in the sample have to be estimated regularly. For
example, if the index is reported quarterly, the properties included in the index
have to be reappraised quarterly. This regular estimation of the property values
requires a large amount of work. There could therefore be some instance where
the period of the index construction and the property valuations are different. An
example of such indices is NCREIF Index, which is compiled and reported
quarterly, but in fact, most properties are reappraised just once a year. Thus, it is
more accurate to rely on it as on annual index, partially updated each quarter. In
contrast, JLW and IPD are truly quarterly indices, because each property included
14 Property valuation and appraisal indices
in an index is reappraised every period in which the index is compiled and
reported.
Some appraisal-based indices exist in the following countries:

USA
NCREIF Property Index (NPI) is the most widely used index of investment
performance of income property. It has been constructed since the fourth quarter
of 1977. NPI is based on the appraisal values of properties held for tax-exempt
institutions by members of the National Council of Real Estate Investment
Fiduciaries. The index is computed and reported on a quarterly basis. NPI now
contains almost 35,000 institutionally owned properties valued at over $543.5
billion. It also consists of over 150 open-end and closed-end funds. The objective
of the NPI is to provide a historical measurement of property-level returns to
increase the understanding of, and lend credibility to, real estate as an institutional
investment asset class. The property return is weighted by its market value.
Even though it includes properties with leverage, all returns are reported on an
unleveraged basis. The index includes apartments, hotels, industrial, offices and
retail properties, and sub-types within each type. The NPI is a composite index
defined by the membership of NCREIF and the index is analogous to the New
York Stock Exchange (NYSE) composite index based on the stocks listed on that
exchange. Geographically, the index is available by region, division, state, CBSA
and Zip Code.

UK
The most widely used indices in UK are Investment Property Databank Index
(IPD), Jones Lang Wootton (JLW) and Investors Chronicle Hillier Parker
Index (ICHP). The IPD Index was established in 1984. Now it is the main pro-
perty index in the UK. IPD is computed and reported on a monthly, quarterly and
annual basis and has several sub-indices (including office, industrial and retail). The
index tracks the performance of 22,530 property investments and 970 portfolios
with a total capital value of £202.2 billion as at the December 2016. The IPD Index
also exists in many countries including Australia, Austria, Belgium, Canada, Czech
Republic, Denmark, France, Germany, Hungary, Ireland, Italy, Japan, Korea,
Netherlands, New Zealand, Poland, Portugal, South Africa, Spain, Sweden, the
UK and the USA.

Other countries
Appraisal-based indices are also compiled in:

• Canada (the Russell Canadian Property Index, RCPI) since the beginning
of 1985
• Australia (Property Council of Australia, PCA)
• Germany (Deutsche Immobilien Index, DIX) since 1996
• Hong Kong (JLW Hong Kong Index)
 Property valuation and appraisal indices 15
• New Zealand (BOMA New Zealand)
• South Africa (Richard Ellis and IPD).

Conclusion
In this chapter, we have demonstrated that real estate transaction information,
even though is important, is difficult to come by. This is true especially when it
comes to non-residential real estate. This is because the non-residential proper-
ties are hardly sold – the common form of property transfer with these real estate
markets is through renting. Transaction data by definition is virtually not in
existence in these markets. In most developing residential markets, too, trans-
action data is virtually not in existence in these markets. The concept of property
valuation and the role of the value in estimating the capital value of properties,
both residential and non-residential, cannot be overemphasised. This chapter has
discussed the various traditional methods and has identified some of the existing
appraisal-based indices across the globe. The chapter has indicated the weaknesses
involved in using any of the traditional valuation methods to estimate the value
of the property. The focus of this book is on transaction data-based and residential
property indices. In the next chapter, a global tour of residential property indices
is provided.
3 A global tour of transaction
property price indices

Introduction
Index numbers are used to aggregate detailed information on prices and quantities
into scaler measures of price and quantity levels or their growth (Diewert, 2008).
Presenting this detailed information in the form of indices makes it easy to see
how the prices and quantities have changed over time and also to facilitate
comparisons of series with different units of measurement (Brooks and Tsolacos,
2010). Index numbers are widely used to display series for gross domestic product
(GDP), consumer prices, stock prices, exchange rates, house prices etc. It is very
important to ensure that the index numbers relied upon are accurate, timely and
robust. Obviously, the methodology used to construct the indices will determine
how accurate and robust the index numbers are. All the transaction property
price indices discussed in this chapter are residential and this is the focus of
this book.
This chapter discusses the uses of residential real estate price indices as well
as the existing indices in some selected countries such as the USA, Sweden,
Germany, New Zealand, Australia and the UK. Among other indices, the S&P/
Case-Shiller indices in the USA are discussed. The second section discusses the
attributes of good property price indices. In the third section, the existing property
price indices in some selected markets are highlighted and the discussion is
narrowed down to the UK market in the fourth section: notably, the Halifax,
the Nationwide, the Land Registry and the Aberdeen house price indices are the
main existing indices discussed here. The coverages and methodologies of these
indices as well as their limitations are all discussed. The aim is to show the gap
that exists in the market. The chapter concludes with a summary of the EU
directive on national house price indices and standard methodologies in the fifth
section.

Uses of residential real estate price indices

Individuals and organisations use real estate price indices for different purposes in
many areas of society. The different uses of the index numbers can influence the
coverage, frequency and the methodology to employ when estimating the index
 A global tour of transaction indices 17
numbers. From the perspective of most individuals or households, real estate
represents the single largest in their portfolios. It accounts for the largest share
of wealth for most nations. The implications for changes in house prices on
individuals and households cannot be overemphasised. The levels of and changes
in house prices influence home improvement and expenditures incurred on reno-
vations. Thus, changes in house prices affect overall consumer spending through
the wealth effect. In the measurement of the affordability of homeownership,
house prices play a major role.
Policy-makers, analysts and players in the financial markets also depend on
house price information for decision-making. They use it to measure the sound-
ness and financial stability of their mortgages as well as to monitor the impact on
economic activities. The various uses of residential real estate price indices are
discussed in this section.

Inflation and monetary policy targeting

In most countries, inflation targets are directly linked to property price indices.
The monetary conditions index (MCI) utilised by some central banks also
includes some measure of house prices because house prices play an important
role in controlling inflation and ensuring economic development (Jarocinski
and Smets, 2008). Inflation targets based on the consumer price index (CPI) will
indirectly consider the movement in house prices when setting interest rates. An
inflation target is used by many countries to define and operate their monetary
policy ranges (Fenwick, 2013). As a result of this, residential property prices are
likely to play an increasing role in the conduct of monetary policy.

Financial stability indicators

Financial stability indicators (FSIs) show the current health and soundness of the
financial system and institutions of a country. All the indicators that represent
the markets in which the financial markets and institutions operate are considered
together in measuring the soundness. These include statistics on real estate prices.
The International Monetary Fund (IMF) developed FSIs so as to monitor and
strengthen the global financial system and also to increase financial stability
following the financial market crises in the 1990s. This is seen as a way of pre-
venting such global financial crises. In order to provide such financial stability
indicators, a compilation of accurate and reliable house price indices is needed
(Fenwick, 2013). When house prices fall sharply, the health and stability of
the financial sector is greatly affected and especially so in developed countries.
Many studies have documented that real estate cycles and economic/business
cycles are directly related (see for example Pholphirul and Rukumnuaykit, 2010).
The role of real estate in financial crises especially in the developed world is well
documented since most residential purchases are done through mortgages (see for
example Wu et al., 2015).
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