Saturday 7 November 2009

How good are real estate price indexes?

Each week, I open the local rag and have a look at a table that they publish on local house prices. They always track whether prices are going up or down, and by how much. This week, prices were down 2.8% on last year.

I can't stand these sorts of indexes, as they are notoriously open to all sorts of abuse and interpretation.

I wish they'd produce an index that is based on cost per square metre - either of the land parcel or the house or the two combined.

Say you spend $750,000 buying a run down shack on a 1000 sqm block. As the shack is worthless, the land is obviously worth $750 per square metre.

A year later, after a McMansion is constructed, the place sells for $1.1 million.

Under our existing index, the real estate industry would be crowing that values are up 46% in a year. Buy now! Great investments to be had! You too can make a killing in real estate!

However, what if the house cost $500,000 to build? I'd say the owners just sold out at a $150,000 loss, and that does not include the costs of conveyancing, stamp duty and the interest on whatever they borrowed to buy and build.

Or consider a house that starts at say 200 square metres, and is valued at $800,000. The owners extend upwards and outwards, ending up with a 300 square metre house. The place sells for $1.1 million. Have they just realised a 37% gain?

Well, my index would say that you started with a package worth $400 per square metre of house. You ended up with a package worth $366 per square metre.

It's not like you are comparing the price of apples across time. I am pretty sure that the apples we were eating in 1960 are fairly similar to those eaten today (at least for those varieties like the Granny Smith that have been around that long). With apples, at least we know we are comparing roughly the same goods from year to year.

With houses, you aren't. The house my parents live in looks nothing like it did when they bought it. They have renovated very extensively, altering most rooms in one way or another. People install swimming pools, knock the back off and extend backwards, demolish pre-war fibro dog boxes and replace them with brick McMansions, demolish outdoor toilets and move the bathroom indoors (yes, a friend had to do that in the mid 1990's).

One thing we do know is that the houses that were built in the 1950s were much smaller than those being built today. Is there any real estate index that factors that in? Do any of them take inflation into account?

I do know one thing is for sure - real estate spruikers will do anything to fiddle the stats to make them look as positive as possible.

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