There is no perfect measure for any broad financial market activity. Markets for stocks, bonds and other securities are the most widely reported and measured financial markets. It is relatively easy to measure activity in these markets because all sales are recorded at a few central exchanges and the “products” are uniform (one share of stock is equal to another). In contrast, real estate markets are much more difficult to evaluate. Real estate transactions are recorded into the public record in thousands of locations across the country. Keeping an organized database of these records is such a daunting task that the title insurance industry has taken this responsibility as part of its business model, and many people are devoted to the arduous task of obtaining and organizing these records on a daily basis.
Real estate does not have the uniformity of stocks or other financial instruments. Each property has unique qualities that differentiate it from all other properties making like-kind comparisons very difficult. Geographical location is a major influence on the value of real estate. Even if two properties could be found with identical physical characteristics, the values of these properties could vary considerably based on where they are located. Ideally, a market measure would record the changes in sales prices of identical assets or in the case of an index, a group of similar assets. The unique nature of real estate assets makes it difficult to use standard measures of reporting utilized in other financial markets.
Due to the problems of asset uniformity and variability based on location, real estate markets are typically measured using some form of median pricing over a specified geographic area. The median is a statistical measure of central tendency where half the data points are above and half the data points are below. For instance, in a list of 5 numbers sorted by size ($100,000, $200,000, $300,000, $500,000, $900,000,) the third number in the list ($300,000) would be the median because it has two numbers that are larger and two numbers that are smaller. The median ($300,000) is used rather than an average ($400,000) because a few very expensive properties can increase the average significantly, and the resulting number does not represent the bulk of the price activity in the market.
Median Home Prices, 1968-2006
Median is Not Perfect
One of the problems with a median as a measure of house prices is a lag between when a top or a bottom actually occurs and when this top or bottom is reflected in the index. During the beginning of a market decline, the lower end of the market has a more dramatic drop in volume than the top of the market. This causes the median to stay at artificially high levels not reflective of pricing of individual properties in the market. In other words, for a time things look better than they are.
Then as the price decline takes hold, transaction volume picks up at the low end and drys up at the high end. The flood of low-end transactions at much lower price points makes the median snap back and make the decline look worse than it really is.
Finally, as the price decline wears on, transaction volume will begin to accelerate at the high end — at much lower price points. This activity is still above the median, so the median moves higher whereas prices are actually moving lower.
At the beginning of a market rally, transaction volume picks up at the bottom of the market at first restarting the chain of move ups. During this time, the prices of individual properties can be moving higher, but since the heavy transaction volume is at the low end, the median will actually move lower.
With all variability caused by changes in the product mix, the median is a poor record of market tops and bottoms, and it is prone to show a direction of market prices that is incongruous with what is happening with individual properties.
Other Distortions of Median
The median has another significant weakness: it does not indicate the value buyers are obtaining in the market. The houses or structures built on the land compose the most significant portion of real estate value in most markets. These structures deteriorate over time and require routine maintenance that is often deferred. During times of prosperity, many people renovate homes to add value and improve their living conditions. The impact of deterioration and renovation of individual properties is not reflected in the median resale value.
Also, at the time of sale, there are often buyer incentives which inflate the recorded sales price relative to the actual cost to the buyer. These buyer incentives also distort the median sales price as a measure of value.
Median is the Best We Have
With all these distortions of market reality, it is a wonder the median is used at all. Winston Churchill noted, “It has been said that democracy is the worst form of government except all the others that have been tried.” The same is true of the median. We use it not because it is perfect, but because it is the best available for the task. Despite its weaknesses, distortions in the index are not extreme, and it is the best tool available that provides a meaningful number.