Price formation induced spatial autocorrelation : an empirical analysis

Abstract

Hedonic models are popular in explaining real estate prices, but they ignore an important source of informational spill-over during market participants’ valuation process: comparable transactions in the past. This research will trace this omitted influence of comparable transactions on real estate prices.

Previous research into spatial autocorrelation in real estate data introduced spatio-temporal lagged price information with the aid of weight matrices. While these works hinted on informational spill-over effects as a culprit of spatial autocorrelation, they did not include all important known factors of the valuation process with comparable transactions in the weight matrix specification.

This work improves the weight matrix specification by explicitly including the following observations: Market participants select comparable transactions that share very similar hedonic characteristics with the property to be valued. When selecting comparable transactions, they search for the transactions that are most comparable with respect to the three dimensions space, time and hedonic characteristics. Market participants utilise only a certain number of best comparable transactions to conduct their valuation.

Hedonic distance is a new construct that aggregates absolute differences between two properties along all known hedonic characteristics on one scale. Following the intuition that at the point of valuation, market participants select past comparable transactions that are not only recent in time and adjacent in space but also similar in hedonic characteristics with the property to be valued. The inclusion of the hedonic distance is shown to improve model performance.

Market participants’ mental trade-offs between the three dimensions of spatial, temporal and hedonic distance are empirically assessed. Discovering the best comparable transactions around a target property along a single dimension, such as space, is simple – these are the most adjacent transactions. However, this search for the best comparable transactions becomes an empirical question when repeated in three dimensions. In this multi-dimensional space, the relative importance of each dimension during valuation can be expressed in trade-off parameters. This work assesses the trade-off parameter between spatial and hedonic distance and shows that 300m in spatial distance is equidistant to HK$1M in hedonic distance during market participants’ selection process of comparable transactions.

The scale of the pricing process with comparable transactions is examined. This work finds that on average market participants use three comparable transactions to value a property at hand. This research also examines the changes in reliance on comparable price information across market conditions to improve the theoretical foundation of this study. While a high price disturbance of comparable transactions is shown to point towards decreasing reliance on this source of information, higher liquidity does not seem to have the positive effects that were indicated by previous research efforts.

This research contributes to the academic discussion by modelling small-scale, price-formation-induced spill-over effects on prices. This may allow quantitative analysts to improve their forecasts based on hedonic models. Practitioners, who use market-based valuation techniques, may benefit from empirical insights how market participants select and weigh comparable transactions during their valuation process.