Transaction-based indices are widely seen as the best to reflect movements of true market prices. The hedonic method is able to solve the problem of heterogeneity very well, by adjusting for quality. The shortcoming of transaction-based indices is the necessity to observe enough individual transactions. For office buildings in a mid-size city, there are just not enough transactions to have the representative sample that is needed to calculate a transaction-based index on a reasonably frequent basis. In such a case appraisal-based indices apply.
Property indices are classified along two main dimensions: type of property and geographical expansion. Geltner and Miller (2001) define the categories:
- Residential owner-occupied housing
- Residential apartment renters
- Retail
- Office
- Industrial
- Hotel and convention
Except owner-occupied residential housing, the categories cover commercial purposes. Data sets are very different for owner-occupied housing and commercial real estate. For owneroccupied housing, no rent is observed and thus a discounted cash flow (DCF) method cannot be applied. On the other hand, prices of many transactions and the corresponding property characteristics can be recorded. For the commercial categories, fewer transactions are typically observed. However, DCF methods and other valuation methods can be applied due to the generated income stream. In summary, owner-occupied housing indices are usually based on transactions, while commercial property indices are based on appraisals.
In addition, there are indices that are based on indirect real estate vehicles such as REITs, funds and real estate companies. The advantage of using these indices as underlying instruments for derivatives is their public observability in the market. The disadvantage, however, is the typically relative low correlation to direct property investments. Hence, they do not accurately represent real estate prices and are rarely suitable as a substitute for direct property indices. Also, real estate companies are subject to management risk.1 A derivative on an index of property companies is simply a derivative on a stock basket. On the Chicago Mercantile Exchange (CME) and the Chicago Board Options Exchange (CBOE), options on REIT indices (e.g. the Dow Jones Equity REIT Index) have already been traded for quite a while. The question is which market is reflected by the index performance. Indices consisting of property companies are typically much more volatile than indices of direct property investments and are influenced by the general equity market.