What happened to home prices in 2007? It depends who you ask.

The Case-Shiller index says prices dropped 9%. The National Association of Realtors says prices only dropped 3%. The Federal Government says prices actually rose 1%.

What’s going on? The problem is that there is no straightforward way to calculate average home prices. In the stock market, stocks are traded every day and it is easy to tell what a stock’s price is at the end of the day. In the real estate market, a home may be bought one year and not sold again until 10, 20, or 30 years later. And a home that is bought, for example, in 1988 and sold ten years later may have changed quite a bit over the years. Maybe a bedroom was added, or the kitchen was upgraded. Or maybe what was once a brand new home has turned into a fixer upper.

The National Association of Realtors calculates the average price of all existing-home sales—single-family homes, condos, and co-ops. The problem with their approach to calculating home price changes is the sensitivity of the average to changes in the composition of homes sold over time. For example, if prices hadn’t changed at all from 2006 to 2007, but most of the homes sold in 2006 were million dollar homes while most of the homes sold in 2007 were $100,000 homes, then the average price will look like it fell from 2006 to 2007, even though what changed was not home prices but rather the composition of homes sold!

In order to tell whether prices have truly been rising or falling, we need to compare the prices of individual homes over time, and not compare the prices of different baskets of homes. The other two indexes try to do this, but their conclusions are quite different. The Case-Shiller index says home prices fell by 9% in 2007, but the federal government says home prices rose by 1%. Both indexes try to compare the prices of individual homes, but they do it in somewhat different ways and such comparisons are inherently tricky for both.

Another problem is that the Case-Shiller index does not cover the entire country. It does not have any data for 13 states and has incomplete data for another 29 states. Some of the strongest housing markets in the country (Idaho, Montana, and Wyoming) are omitted from the Case-Shiller and others are only partially covered, which would help explain why their index is so gloomy.

In addition, the Case-Shiller index gives more importance to expensive homes than to less expensive ones, while the federal government’s index does the reverse. If modestly priced homes are doing well and expensive homes are suffering, the Case-Shiller index will say that home prices are going down and the federal government will say that home prices are going up.

Are you confused yet? You should be.

But IT DOESN’T REALLY MATTER, because when you are thinking about buying a home, national home price indexes don’t really matter.
What’s the bottom line?

1. Don’t pay a lot of attention to home price indexes. They are complicated, confusing, and contradictory.

2. All real estate is local. If you live in Indianapolis, what do you care about home prices in Detroit, Houston, or Las Vegas?

3. The real question for homebuyers is not how home prices today compare to home prices last year or 20 years ago, but instead how the costs and benefits of homeownership stack up. Do the benefits outweigh the costs, or vice versa? In
Houseonomics: Why Owning A Home Is Still A Great Investment , we explain how to calculate the benefits and how to calculate the costs. This comparison is what really matters.