Transaction-based Indices
Evaluating the average price of recently sold commercial real estate property in a given period
What are Transaction-based Indices?
Transaction-based indices refer to a mode of monitoring the performance of the commercial real estate market. Such indices are rare since the acquisition of property is a personal endeavor. Appraisal-based indices are the most common form of indices since, to some extent, investors are obliged to revalue the assets they hold. Consequently, the appraisal-based index gives lagged and smoothed price estimates in the market.
Measuring the performance of the real estate market is challenging since there is no central point where the data is captured, especially in the private sector. The factors contributing to the difficulty in indices construction are the heterogeneity and the sparse trading of such assets. It means that the follow-up for the acquisition of these properties is tedious.
Summary
- Transaction-based indices are computed by evaluating the average price of recently sold commercial real estate property in a given period.
- Transaction-based Indices are preferred to appraisal-based indices since they are based on more recent statistics than the latter.
- Appraisal-based indices are the most commonly used in evaluating the performance of the real estate industry since they are easier to obtain because of readily available data.
Types of Transaction-based Indices
Transactions-based indices can be categorized into two: statistical and ad hoc. The statistical type can be further divided into two: the repeat sales regression and the hedonic regression. The ad hoc category includes the median and average prices.
The statistical type is known for optimizing with regard to econometric principles, which minimize the error level close to zero. The statistical methods can regulate the differences in property values and between durations. The ad hoc methods cannot optimize according to econometric principles and cannot control the difference between property values or periods.
However, all the methods above can be either value-weighted or equal-weighted in the construction of indices. The equal-weighted averages are the most superior due to their ability to maneuver according to statistical principles.
Developing a Transaction-based Index
The easiest method of computing a transaction-based index is by taking the mean of all accessible assets traded in a particular period. Taking the average means that there is both the difference in property quality and the market movements in the number of sales in a particular period.
The average, therefore, puts into perspective the market value and the fluctuations in the value of assets being sold. Hedonic regression is thus used to control the effects of asset price characteristics in index construction. Another common approach for developing indices is the repeat sales regression method.
A rigorous process is followed in developing transaction-based indices. The process involves in-depth research and background checks on recent transactions. Collected samples are then sorted for sample inclusion. To eliminate property-specific factors and for comparison purposes, a criterion is laid out for the construction of the indices.
Pros of a Transaction-based Index
There’s no doubt that appraisal-based indices are the most popular form of indices used to evaluate the performance of the real estate industry. However, transaction-based indices better express the real estate industry’s performance. It refers to real-time prices instead of valuation-based indices, which refer to past prices since valuation is done in the past.
Again, valuation prices are partially based on the comparison of recently sold properties. The challenge occurs in obtaining recent transactions on acquisitions. Properties are sold infrequently and silently from the public eye. Appraisal-based indices tend to draw criticisms due to lagging transaction prices, which are developed from previous valuations.
NCREIF Transaction-based Index (NTBI) vs. NCREIF Price Index (NPI)
The NCREIF Transaction-based Index (NTBI) is an index equally weighted between the transaction and appraisal indices. The NCREIF Price Index (NPI) is evaluated using the valuation values of appraisal-based indices. Both methods are used to measure the performance of the real estate market.
The NPI is best suited for evaluating hotels; the NTBI can’t be used on hotels based on the NCREIF databases. The NCREIF intends to further the index types, but currently, the only possible indices are industrial, retail property, apartments, and office type of indices.
NCREIF Equal-Weighted Indices
The use of an equal-weighted index regularizes the effects of the difference in features and value in the properties being sampled. The use of equal-weighted indices makes every sampled property an active contributor in the indices. Such a practice makes it ideal for comparison purposes.
The equal-weighted NPI is also characterized by being less volatile and hence, more diversified. It is because the NPI is not dominated by a few large properties that can cause volatility. The equally weighted indices assure that the trends remain constant apart from a few fluctuations in quarters that come from the difference in the type of properties transacted.
Related Readings
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)® certification program, designed to help anyone become a world-class financial analyst. Through financial modeling courses, training, and exercises, anyone in the world can become a great analyst.
To keep advancing your career, the additional CFI resources below will be useful:
