Home Improvements and Appreciation Rates Reflected in the OFHEO House Price Index

The repeat-transactions model that is used in the construction of OFHEO's house price index (HPI) does not perfectly control for changes in the average condition of the housing stock. If the value of home improvements is not exactly offset by the effects of home depreciation, the HPI could reflect more or less appreciation than would be reported in a true quot;constant qualityquot; index. This paper attempts to measure the annual amount of quot;quality driftquot; embedded within the index. The analysis focuses primarily on measuring quality change gross of the effects of depreciation. Three approaches are used: one based on macroeconomic measures of remodeling expenditures, another based on data from the American Housing Survey, and a final investigation focused on building permit data obtained from the City of San Francisco. While improvements-related appreciation is not detected in the San Francisco data, the other two approaches suggest that the inflationary impact of home improvements could be between about 0.4 and 1.0 percent per year. Given these estimates, if offsetting home depreciation is around 1.1 percent per year (as some have presumed), the HPI will reflect less appreciation than would be found in a constant-quality index. The net quot;quality driftquot; embedded in the HPI would then be in the range of -0.1 to -0.7 percent per year, with a slightly wider range plausible under more extreme assumptions