The real estate industry is inextricably linked to the entire economy. A rise within the residential industry is a direct result of a rise in the GDP of a country. Therefore, a decrease in caused by real estate also leads to economic chaos. It is because of this that real estate has to be carefully monitored by government. By observing the real estate market, the government can pinpoint problems related to real estate prior to they become significant or even major. The issues are then corrected through either monetary or fiscal policy. But, the problems need to be identified prior to a solution is made. Therefore, there is a requirement for an index for the cost of real estate.

The ideal way to use an index is that it can serve as a gauge for the whole market. However, the construction of real estate indices can be complicated due to the very nature of the asset. In the article below, we’ll look at some of the typical problems that arise when creating real estate price indexes.

Common Problems Associated With Creation of a Real Estate Price Index

• Heterogeneity: First of all, it is an entirely different type of asset by its nature. It cannot be compared to other assets, such as bonds and stocks. The real estate market is a diverse one. are not homogeneous or fungible. The nature of transactions in real estate vary from one area to the next. This is why the price fluctuations are not easily measurable. This is the most difficult aspect of making a real estate price index.
• Liquidity: Bonds and shares are frequently traded at any price. Investors receive information on the quantity of bonds and shares that were sold at a specific price in order to provide them with an idea of the authenticity of the prices quoted. However, this is not the case for real property. When prices drop sellers are able to hang the property and put off selling. This is why the negative sentiment and the decline in properties are not accurately represented in a real estate price index.
• The frequency of reporting In contrast to bonds and stocks, real estate doesn’t have an investment cycle that is short. This means that real estate prices do not fluctuate on a daily basis. This is why it’s not required for real estate indices to offer a new quote every day. The majority of the real estate indexes provide a quote each three or six month. The fluctuation in the real estate market isn’t easily discernible. You must track an identical index for a full year to gain a sense of the market for property.
• Incorrect Valuation: Investors do not have a reason to misreport the worth of their shares and bonds. But this isn’t the case for selling property. Taxes on property sales can amount to a significant amount. To avoid having to pay massive tax, it’s not common to declare a lower cost for the tax authorities. Lower prices result in an increase in profits and less tax for the individual affected. The balance is made in cash and typically not recorded. This false reporting distorts the overall picture. As a result, price indices do not give accurate information.

Methods of Creating a Real Estate Price Index

• The easiest way to build the index would be to create a weighted average of all transactions in property that were recorded during the specified time. This isn’t the most reliable. It is however practiced in countries like Germany, Netherlands, Spain and Australia.The biggest issue in this approach is that it doesn’t take into account that properties can be heterogeneous. Because all properties are mixed, the results are not accurate at most.
• In other words, if the values of urban areas keep rising while those in rural areas have fallen, however, the index may have a positive trend!
• To solve the problem mentioned above, Many economists employ the Hedonic method. In this approach, the index is not able to provide a single value. Instead, the market for property for the whole nation is broken down into a variety of micro-markets. This could be in the context of the rural-urban divide or based on significant cities.The concept is to create micro markets in which properties that have similar characteristics are combined. Furthermore, the value of each property can be compared with a base year.
• For instance, if for the value of all properties in the year 2010 were thought to be 100 and the index shows the value of the year of 2018. In the case of 160, there has been a 60 percent increase over the 8-year time frame. The issue with this method is that it requires a lengthy calculations.
• A variety of econometric models are employed to determine the index’s final value. The value could be biased because of some of the vested interests. However, in most instances, the information is true and fair.
• This technique is widely used to calculate the value of a home in Scandinavian states, Switzerland, United Kingdom and even India. It is also used in India. National Housing Board Residex Index has been developed following similar principles.

The main point is that various techniques can be employed to make real estate indexes. The selection is based on the accuracy and quantity of the data. It is evident in this report that the real estate indexes perform very differently to other indexes.