Housing Valuation and the Business Cycle: The Hedonic House Price Index Approach

The hedonic price method (Rosen S. J Polit Econ 82:34–55, 1974) has widely been used to assess the demand for, and prices of, housing. This method is founded on the notion that housing is a composite commodity with inherent properties and the value of a house can be estimated by aggregating the assessed values of its separate properties. The properties are not limited to structural differences of houses, but also include locational and neighbourhood characteristics. Scholarly literature suggests house prices are also influenced by the time trend and the business cycle; therefore, time-related (temporal) determinants need to be included in the hedonic model if prices are to be evaluated over time. This chapter examines various strategies that have been implemented within hedonic price method to incorporate the impact of the business cycle. It begins by considering the most common cross-sectional hedonic models, where business cycle effects are largely ignored due to their focus on ‘one point in time’ (e.g. Herath S, Choumert J, Maier G. Ann Reg Sci 54:349–374, 2015). Other functional forms including hedonic panel models, spatial panel models and spatiotemporal models are then reviewed. These models take into account temporal changes including the business cycle effects in a comprehensive way (e.g. Hiller N, Lerbs OW. Reg Sci Urban Econ 60:276–291, 2016). One version of the fixed effects panel model generates time fixed effect coefficients that could be interpreted as a real estate price index – also representing business cycle effects. We also demonstrate an alternative functional form that is capable of representing the time trend and cyclical variation of house prices within the hedonic framework (Herath S. Discovering the urban structure using a spatial Hedonic house price model. In: Wang Y, Shen KLGQP, Bai Y, Xue X, Sun C, Gao Z, Wu Y, Xue W (ed) ICCREM 2013 – Construction and operation in the context of sustainability. American Society of Civil Engineers, 2013). Despite the common challenge of disentangling the business cycle and time trend, the incorporation of the business cycle is an important consideration as any assessment of house prices over time without taking into account temporal dimensions leads to biased estimates.