Magazine article Mortgage Banking

Behind Home-Price Indexes: What You Should Know

Magazine article Mortgage Banking

Behind Home-Price Indexes: What You Should Know

Article excerpt

Indexes of home-price appreciation have become the valuation tool of choice for many investors. The idea is a simple one: You take the last known sales price of a property, multiply it by the index for the ZIP code in which the property is located, and the result is an approximation of what the property should be worth, assuming all other things are equal.

Many investors like indexes of home-price appreciation because they can often secure a site license for this kind of product (for unlimited use), which makes it cost-effective; however, it is often less accurate than alternatives like purchasing individual automated valuation models (AVMs) for the same quantity of loans. Once the approximate value of the property has been determined, then the potential investor can engage in a variety of other analyses.

The methodology associated with constructing home-price indexes (HPIs) is rather old, with papers published on this topic dating back to as early as 1971. Beyond that, indexes of home-price appreciation were popularized in the trade press by the "three professors" (Case, Shiller and Weiss). Subsequently, the Federal Housing Finance Agency (FHFA)--formerly the Office of Federal Housing Enterprise Oversight (OFHEO)--developed its own set of home-price indexes based on the data derived from both Fannie Mae and Freddie Mac. Since the mid-1990s, indexes of home-price appreciation have also been available on a licensing basis from AVM developers.

Testing HPI accuracy

Potential users of HPIs are presented with a variety of considerations when determining which index to utilize. Beyond cost, accuracy is tremendously important in today's risk-focused environment. It is possible to test indexes of home-price appreciation in much the same way that AVM developers test their products. The purveyors of home-price indexes can and should present internal testing results that investors can evaluate as part of their due-diligence process.

Certainly, the true test of the viability of an HPI is its ability to accurately approximate the current value of residential property as evidenced by its most recent sales price. Here is how this works: Suppose a property sold in July 201.0 in ZIP code 92782 for $900,000 and in January 2007 the same property sold for $1.3 million. The way to test the validity of the index in this example is to multiply the relevant index times $1.3 million and compare it with the most recent purchase price of $900,000, If this process is repeated over a large enough sample set (a minimum of 30 observations per county or cohort), investors can begin to gauge the accuracy of the index.

The main performance criterion investors should use when comparing indexes is to evaluate which index provides the user with the greatest percentage of valuations within plus or minus 10 percent of the sales price. Good indexes of home-price appreciation should yield accuracy levels of at least 40 percent. This means that 40 percent or more of the time, the indexed value of the property is within plus or minus 10 percent of the most recent sales prices.

The time factor

Using accurate and timely HPIs is also the backbone of all good AVMs. We all know that appraisers use a database of three comparable properties to arrive at their conclusion of value. …

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