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Chapter 6 THE PARIS OECD-IMF WORKSHOP ON REAL ESTATE PRICE INDEXES: CONCLUSIONS AND FUTURE DIRECTIONS

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Chaper 6 THE PARIS OECD-IMF WORKSHOP ON REAL ESTATE PRICE INDEXES: CONCLUSIONS AND FUTURE DIRECTIONS W. Erwin Diewer 1 1. Inroducion This paper highlighs some of he hemes ha emerged from he OECD-IMF Workshop
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Chaper 6 THE PARIS OECD-IMF WORKSHOP ON REAL ESTATE PRICE INDEXES: CONCLUSIONS AND FUTURE DIRECTIONS W. Erwin Diewer 1 1. Inroducion This paper highlighs some of he hemes ha emerged from he OECD-IMF Workshop on Real Esae Price Indexes which was held in Paris, November 6-7, 26. The paper discusses possible uses and arge indexes for real esae price indexes and noes ha a major problem is ha i is no possible o exacly mach he qualiy of dwelling unis over ime due o he fac ha he housing sock changes in qualiy due o renovaions and depreciaion. Four alernaive mehods for consrucing real esae price indexes are discussed: he repea sales model; he use of assessmen informaion along wih propery sale informaion; sraificaion mehods and hedonic mehods. The paper noes ha he ypical hedonic regression mehod may suffer from specificaion bias and suggess a way forward. Problems wih he user cos mehod for pricing he services of owner occupied housing are also discussed. The paper is organized as follows. Secion 2 discusses he quesion: wha are appropriae arge indexes for Real Esae Prices? This secion argues ha he presen Sysem of Naional Accouns is a good saring poin for a sysemaic framework for Real Esae Price indexes bu he presen SNA has o be augmened somewha o mee he needs of economiss who are ineresed in measuring consumpion on a more comprehensive service flow basis and who are ineresed in measuring he produciviy of an economy. Secion 3 noes he fundamenal problem ha makes he consrucion of consan qualiy real esae price indexes very difficul: namely depreciaion and renovaions o srucures make he usual mached model mehodology for consrucing price indexes inapplicable. Secion 4 discusses four classes of mehods ha were suggesed a he workshop o deal wih he above problem and secion 5 discusses some addiional echnical difficulies. 1 This paper is an exended wrien version of my Discussion a he Concluding Overview session of he OECD-IMF Workshop on Real Esae Price Indexes held in Paris, November 6-7, 26. The financial assisance of he OECD and he Ausralian Research Council is graefully acknowledged, as is he hospialiy of he Cenre for Applied Economic Research a he Universiy of New Souh Wales. The auhor hanks Paul Armknech, Sephan Arhur, David Fenwick, Jan de Haan, Johannes Hoffmann, Anne Laferrère, Alice Nakamura, Marc Prud homme, David Robers, Mick Silver, Paul Schreyer and Kam Yu for helpful commens. None of he above individuals or organizaions is responsible for any opinions expressed in his paper. Diewer, W.E. (29), The Paris OECD-IMF Workshop on Real Esae Price Indexes: Conclusions and Fuure Direcions, chaper 6, pp in W.E. Diewer, B.M. Balk, D. Fixler, K.J. Fox and A.O. Nakamura (29), PRICE AND PRODUCTIVITY MEASUREMENT: Volume 1 -- Housing, Trafford Press. Also available as a free e-publicaion a and Alice Nakamura, 29. Permission o link o, or copy or reprin, hese maerials is graned wihou resricion, including for use in commercial exbooks, wih due credi o he auhors and ediors. Secion 6 discusses he problems raised by Verbrugge s (26) conribuion o he Workshop; i.e., why do user coss diverge so much from rens? Finally, secion 7 summarizes suggesions for moving he agenda forward, including a proposal for a new approach o accouning for real esae in measures of inflaion. 2. Wha Are Appropriae Targe Indexes? There are many possible arge real esae price indexes ha could be consruced. Thus i is useful o consider alernaive uses for real esae price indexes ha were suggesed a he workshop since hese uses will largely deermine wha ype of indexes should be consruced. Fenwick (26; 6) suggesed he following lis of possible uses for house price indexes: As a general macroeconomic indicaor (of inflaion); As an inpu ino he measuremen of consumer price inflaion; As an elemen in he calculaion of household (real) wealh, and As a direc inpu ino an analysis of morgage lender s exposure o risk of defaul. Arhur (26) also suggesed some (relaed) uses for real esae price indexes: Real esae price bubbles (and he subsequen collapses) have repeaedly been relaed o financial crises and hus i is imporan o measure hese price bubbles accuraely and in a way ha is comparable across counries, and Real esae price indexes are required for he proper conduc of moneary policy. Fenwick also argued ha various real esae price indexes are required for deflaion purposes in he Sysem of Naional Accouns (SNA): The primary focus of a naional accounan seeking an appropriae deflaor for naional accouns will be differen. Real esae appears in he Naional Accouns in several ways; he impued renal value received by owner occupiers for buildings, as opposed o land, is par of household final consumpion, he capial formaion in buildings, again as opposed o land, is par of gross fixed capial formaion, depreciaion, and he measuremen of he sock of fixed capial, and land values are an imporan par of he Naional sock of wealh. David Fenwick (26; 7-8) 88 Fenwick (26; 6) also argued ha i would be useful o develop a coheren concepual framework for an appropriae family of real esae price indexes 2 and he provides such a framework owards he end of his paper. 3 Diewer, in his oral presenaion o he Workshop, followed Fenwick and argued ha in he firs insance, real esae price saisics should serve he needs of he SNA. The reason for his is ha (wih one excepion o be discussed laer) he SNA provides a quaniaive framework where value flows and socks are sysemaically decomposed in an economically meaningful way ino price and quaniy (or volume) componens. The resuling p s and q s are he basic building blocks which are used in virually all macroeconomic models. Hence i seems imporan for price saisicians o do heir bes o mee he deflaion needs of he SNA. Before he main problem area wih he presen SNA reamen of real esae is discussed, i is useful o review a bi of basic economics. There are wo main paradigms in economics: Consumers or households maximizing uiliy subjec o heir budge consrains, and Producers maximizing profis subjec o heir producion funcion (or more generally, heir echnology) consrains. There are one period saic and many period ineremporal versions of he wo paradigms. However, for our purposes, i suffices o say ha he SNA provides he necessary daa o implemen boh models excep for he fac ha he SNA does no deal adequaely wih he consumpion of consumer durables for he needs of eiher consumer or producer modeling. The problem is ha when a consumer or producer purchases a good ha provides services over a number of years, i is no appropriae o charge he enire purchase cos o he quarer or monh when he durable is purchased; he purchase cos should be spread ou over he useful life of he durable. However, wih he imporan excepion of residenial housing, he SNA simply charges he enire cos of he durable o he period of purchase. 4 This is no an appropriae reamen of durables for many economic purposes. Thus, for he SNA household accouns, in addiion o he usual acquisiions approach reamen of consumer durables (which simply charges he enire purchase cos o he period of purchase), i would be useful o have alernaive measures of he service flows generaed by household holdings of consumer durables. There are wo alernaive approaches o consrucing such flow measures: An impued ren approach which impues marke renal prices for he same ype of service (if such prices are available), and A user cos approach which forms an esimae of wha he cos would be of buying he durable a he beginning of he period, using he services of he durable during he period and hen selling i a he end of he period. This esimaed cos also includes he ineres cos ha is 2 I can be seen ha user needs will vary and ha in some insances, more han one measure of house price or real esae inflaion may be required. I can also be seen ha coherence beween differen measures and wih oher economic saisics is imporan and ha achieving his will be especially difficul as saisicians are unlikely o have an ideal se of price indicaors available o hem. David Fenwick (26, p. 8). 3 See Fenwick (26, pp. 8-11). 4 More specifically, for owner occupied residenial housing, he SNA incorporaes esimaes of he period by period flow of housing services. One reason his is done is o improve he comparabiliy of he SNA beween naions where he percenage of households living in owner occupied versus renal housing is very differen. 89 associaed wih value of he capial ha is ied up in he purchase of he durable. 5 However, if mos owners of some sor of durable, in fac, coninue o hold i for muliple periods, hen he buy-use-sell sequence migh be priced ou as a per-year average over he expeced holding period, using he available informaion on he beginning and end of period prices and he ransacion coss ha would be involved in buying and hen selling once over he expeced holding period. We discuss he relaive meris of he above wo service flow mehods for valuing housing services in secion 6 below. For addiional maerial on he various economic approaches o he reamen of durables and housing in paricular, see Diewer (22; ), (23), Verbrugge (26), and Chaper 23, Durables and User Coss, in he Inernaional Labour Organizaion (ILO) Consumer Price Index Manual (24). On he producer side of he SNA, he service flows generaed by durable inpus ha are used o produce goods and services are buried in Gross Operaing Surplus. Jorgenson and Griliches (1967) (1972) showed how gross operaing surplus could be decomposed ino price and quaniy componens using he user cos idea and heir work led direcly o he firs naional saisical agency produciviy program; see he Bureau of Labor Saisics (1983). 6 Schreyer, Diewer and Harrison (25) argued ha his produciviy oriened approach o he Sysem of Naional Accouns could be regarded as a naural exension of he presen SNA where he exended version provides a decomposiion of a value flow (Gross Operaing Surplus) ino price and quaniy (or volume) componens. We will argue below ha if he SNA is expanded o exhibi he service flows ha are associaed wih he household and producion secors purchases of durable goods, hen he resuling Durables Augmened Sysem of Naional Accouns (DASNA) 7 provides a naural framework for a family of real esae price indexes. In his augmened sysem of naional accouns, household wealh and consumpion will be measured in real and nominal erms. This will enail measures of he household secor s sock of residenial wealh and i will be of ineres o decompose his value measure ino price and quaniy (or volume) componens. I will also be useful o decompose he residenial housing sock aggregae ino various subcomponens such as: by ype of housing, by locaion or region, by he proporion of land and srucures in he aggregae value, by age (in paricular, new housing should be disinguished), and by wheher he residence is rened or owned. 5 The user cos idea can be raced back o Walras in 1874; see Walras (1954). 6 The lis of counries ha now have official produciviy programs includes he Unied Saes, Canada, he Unied Kingdom, Ausralia, New Zealand and Swizerland. The EU KLEMS projec (for he EU KLEMS daabase and relaed informaion, see hp://www.euklems.ne/) is developing produciviy accouns for many European counries using he Jorgenson and Griliches mehodology, which is described in more deail in Schreyer (21). For recen exensions and modificaions, see Schreyer (26). 7 Such an accouning sysem is laid ou and implemened for he Unied Saes by Jorgenson and Landefeld (26). 9 Each of hese subaggregaes should be decomposed ino price and volume componens if possible. The DASNA will also require a measure of he flow of services from households consumpion of he services of heir long lived consumer durables such as moor vehicles and owner occupied housing. 8 Thus i will be necessary o eiher implemen he renal equivalence approach (as is currenly recommended in he SNA) or he user cos approach (or some alernaive) for valuing he services of Owner Occupied Housing in his exended sysem of accouns. 9 Turning now o he producer side of he DASNA, for produciviy measuremen purposes, we will wan user coss for owned commercial, indusrial and agriculural properies. In order o form wealh esimaes, we will require esimaes for he value of commercial, indusrial and agriculural properies and decomposiions of he values ino price and volume componens. The price componens can be used as basic building blocks o form user coss for he various ypes of propery. I will also be useful o decompose he business propery sock aggregaes ino various subcomponens such as: by ype of srucure, by locaion or region, by he proporion of land and srucures in he aggregae value, by age (in paricular, new srucures should be disinguished), and by wheher he srucure is rened or owned. If we hink back o he lis of uses for real esae price indexes suggesed by Fenwick and Arhur earlier in his secion, i can be seen ha if we had all of he price indexes for implemening he DASNA as suggesed above, hen virually all of he user needs could be me by his family of naional accouns ype real esae price indexes. The Durables Augmened SNA is a naural framework for he developmen of real esae price indexes ha would mee comprehensive user needs. We urn now o a discussion of he many echnical issues ha arise when rying o consruc a propery price index. 3. Failure of he Tradiional Mached Model Mehodology in he Real Esae Conex Consider he problems involved in consrucing a consan qualiy price index for a class of residenial dwelling unis or business srucures. The saring poin for consrucing any price 8 For shor lived household durables, i is no worh he boher of capializing hese socks; he usual acquisiions approach will suffice for hese asses. 9 We will reurn o his opic in secion 6 below. 91 index beween wo ime periods is o collec prices on exacly he same produc or iem for he wo ime periods under consideraion; his is he sandard mached model mehodology. 1 The fundamenal problem ha price saisicians face when rying o consruc a real esae price index is ha exac maching of properies over ime is ofen no possible for wo reasons: The propery depreciaes over ime (he depreciaion problem), and The propery may have had major repairs, addiions or remodeling done o i beween he wo ime periods under consideraion (he renovaions problem). Because of he above wo problems, some form of impuaion or indirec esimaion will be required. A hird problem ha faces many European counries is he problem of low urnover of properies; i.e., if he sales of properies are very infrequen, hen even if he depreciaion and renovaions problems could be solved, here would sill be a problem in consrucing a saisfacory propery price index because of he low incidence of resales. 11 A fourh problem should be menioned a his poin. For some purposes, i is desirable o decompose he real esae price index ino wo separae consan qualiy componens: A componen ha measures he change in he price of he srucure, and A componen ha measures he change in he price of he underlying land. In he following secion, we will look a some of he mehods ha were suggesed by conference paricipans o consruc consan qualiy real esae price indexes for he land and srucures aken ogeher. The problem of decomposing a real esae price index ino is srucure and land componens is deferred unil secion 5 below. 4. Suggesed Mehods for Consrucing Consan Qualiy Real Esae Price Indexes 4.1 The Repea Sales Mehod The repea sales approach is due o Bailey, Muh and Nourse (1963), who saw heir procedure as a generalizaion of he chained mached model mehodology ha was used by he early pioneers in he consrucion of real esae price indexes like Wyngarden (1927) and Wenzlick (1952). We will no describe he echnical deails of he mehod; we simply noe ha he mehod uses informaion on real esae properies which rade on he marke more han once over he sample period. 12 By uilizing informaion on properies ha are legally he same ha 1 For a deailed descripion of how his mehodology works, see Chaper 2, Elemenary Indices, in he ILO (24). 11 Relaed problems are ha he mix of ransacions can change over ime and in fac enirely new ypes of housing can ener he marke. 12 See Case and Shiller (1989) and Diewer (23, pp ) for deailed echnical descripions of he mehod. Diewer showed how he repea sales mehod is relaed o Summers (1973) counry produc dummy model used in inernaional price comparisons and he produc dummy variable hedonic regression model proposed by Aizcorbe, Corrado and Doms (21). 92 rade more han one period, he repea sales mehod aemps o hold he qualiy of he properies consan over ime. We now discuss some of he advanages and disadvanages of he repea sales mehod. 13 The main advanages of he repea sales model are: The availabiliy of source daa from adminisraive and real esae indusry records on propery sales, so ha no impuaions are involved (if no adjusmens are made for renovaions), and Reproducibiliy of he resuls; i.e., differen saisicians given he same daa on he sales of real esae properies will come up wih he same esimae of qualiy adjused price change. 14 The main disadvanages of he repea sales model are: I does no use all of he available informaion on propery sales; i uses only informaion on properies ha have sold more han once during he sample period. 15 I canno deal adequaely wih depreciaion of he dwelling uni or srucure. I canno deal adequaely wih unis ha have undergone major repairs or renovaions. 16 In conras, a general hedonic regression model for housing or srucures can adjus for he 13 Throughou his secion, we will discuss he relaive meris of he differen mehods ha have been suggesed for consrucing propery price indexes. For a similar (and perhaps more comprehensive) discussion, see Hoffmann and Lorenz (26, pp. 2-6). 14 Hedonic regression models suffer from a reproducibiliy problem; i.e., differen saisicians will use differen characerisics variables, differen funcional forms and differen sochasic specificaions, possibly leading o quie differen resuls. However, in acual applied use, he repea sales model is no as reproducible in pracice as indicaed in he main ex because, in some varians of he mehod, houses ha are flipped (sold very rapidly) and houses ha have no sold for long periods are excluded from he regressions or regression-based adjusmens are made o ry o allow for changes in properies in he inervals beween resale. The exac mehods for making hese sors of adjusmens vary among analyss and over ime o ime, leading o a lack of reproducibiliy. 15 Some of he papers presened a he workshop suggesed ha he repea sales mehod migh lead o esimaes of price change ha were biased upwards, since ofen sellers of properies underake major renovaions and repairs jus before puing heir properies on he marke, leading o a lack of comparabiliy of he uni from is previous sale if he pure repea sales approach is used. For example, Erna van der Wal, Dick er Seege and Ber Kroese (26, p. 3) wrie ha: The repea sales mehod does no enirely adjus for changes in qualiy of he dwellings. If a dwelling undergoes a major renovaion or even an exension beween wo ransacion momens, he repea sales mehod will no accoun for his. The las ransacion price may in ha case be oo high, which resuls in an overesimaion of he index. Andrew Levenis (26, p. 9) wries ha: Research has suggesed ha appreciaion raes for houses ha sell may no be he same as appreciaion raes for he res of he housing sock. Levenis goes on o cie maerial by Sephens, Li, Lekkas, Abraham, Calhoun and Kimner (25) on his poin. Finally, Gudnason and Jonsdoir (26) observe ha: The problem wih his mehod is he risk for bias; e.g., when major renovaion and oher changes have been made on he house which increases he qualiy or if he wear of he house has been high, causing a decrease in he qualiy. Such changes are no capured by his mehod. Furhermore, in Iceland, his mehod canno be used because he numbers of housing ransacions are oo few and hus here are no enough repeaed sales o enable calculaion of he repeaed sales index. 16 Case and Shiller (1989) used a varian of he
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