Price Segmentation, Size Effects and Information Diffusion in Housing Markets

This paper examines issues of information diffusion in housing markets. A large transaction data set for the city of Perth, Western Australia is used to construct market aggregate and price quartile repeat-sales and hedonic indexes for the period 1988-96. Significant size effects are observed. Cheaper properties exhibit higher individual rates of real price change in the short term but the lowest rates in the longer term. These results are consistent for tests with both index models and individual property price changes. These results are shown to cause bias in transaction based indexes. Further tests confirm that information from past price changes diffuses temporally within price segments at varying rates. Abnormal price changes are used to test for information diffusion between price segments. Weaker evidence is presented that lagged information of past price changes diffuses temporally between price segments. The diffusion of information from lower to higher price segments appears to be positive with diffusion from higher to lower segments appearing to be negative. International Real Estate Society Conference ’99 Costello 1.0 Introduction Does information from past price changes diffuse on a consistent temporal scale for different price segments in housing markets? Do cheaper houses increase in price before more expensive properties during market upturns or is there a dominant mean price market segment from which information on price changes diffuses “outwards”. In this paper these questions are applied to transaction data for a specific housing market segment in the city of Perth, Western Australia for the period 1988 – 1996. Surprisingly, there appears to be little empirical work examining information diffusion and the influences of market segmentation in housing markets according to price criteria. The “size effect” where returns on the shares of small companies exceed the returns on the shares of larger companies is frequently discussed in studies of market efficiency in securities markets. Intuition would suggest that there could be similar effects in housing markets. Cheaper house price segments are characterised by greater affordability and therefore increased participation. Does this lead to more rapid diffusion of information? An alternative scenario is that increased affordability causes larger variations in demand and supply for cheaper housing than expensive housing. This in turn creates more volatility and speculative price “bubbles” in cheaper market segments. These are important questions because if inconsistencies between price segments can be observed and predicted, trading strategies might be used to exploit the information contained within past price changes for different price segments. Real estate markets diverge significantly from the theoretical construct of perfect markets. Lagged price information should not affect prices in perfect markets. In real estate markets lagged price information is very important and will affect prices even in the absence of irrationality. The study of house price changes provides a productive source for learning about the informational role of prices. The objectives of this paper are to examine characteristics of house price dynamics that are consistent with rational learning in housing markets. How do buyers and sellers in housing markets obtain and use information? Are there differences in the role of information for past price changes between market segments? These questions are addressed with respect to temporal information diffusion and diffusion between price segments. The influence of lagged information is tested within the aggregate market and price quartile market segments. This paper makes three specific contributions to the existing literature. First, it demonstrates that significant size effects exist in this housing market and therefore price segmentation is an important house price dynamic. Second, size effects can cause significant bias in house price indexes for aggregate housing markets. Third information on past price changes diffuses temporally between price segments and at varying rates in own price segments. The next section of this paper reviews the body of theory and related literature pertaining to the topic. Several hypotheses are suggested concerning relevant information sets applied to definitions of real estate market efficiency. The middle sections of the paper review the data and demonstrate the existence of size effects. The final sections establish the empirical method used to analyse information diffusion processes, review the empirical results and provide some conclusions and suggestions for related research. 2.0 TheoryRelated Literature This paper examines information diffusion in housing markets and hence the informational efficiency of those markets. Fama (1970) developed the efficient market hypothesis (EMH) and defined an efficient capital market as one in which the price of an asset fully reflects all available information. With this rigid definition there is an emphasis on the relationship between market prices and information. With the assumption of perfect markets this emphasis requires that the reaction of prices to new information is both “instantaneous” and unbiased. In an efficient market, competition between informed buyers and sellers should fully reflect the available information set, therefore there can be no biased price reactions. The EMH framework is closely aligned to the