Journal of

Property An application of the ARIMA

Finance
8,2
model to real-estate prices in
Hong Kong
152
Raymond Y.C. Tse
Department of Architecture, The University of Hong Kong

Journal of Property Finance
Vol. 8 No. 2, 1997, pp. 152-163.
© MCB University Press,
0958-868X
Introduction
The foundation for fundamental analysis is supply and demand for the
commodity in question. Fundamental analysis involves modelling the supply-
demand relationships in a market. Analysis of investments, including
commodity futures, can be labelled as fundamental or technical. Supply and
demand are far more difficult to analyse and model than generally realized. To
provide useful results, the analyst cannot deal only with static equilibrium
conditions for a commodity but must incorporate dynamic influences also.
If markets were perfectly efficient, the practice of either fundamental or
technical analysis as a predictive tool would be in vain. No one could hope to
earn consistently higher returns than a naïve investor could do. This research
attempts to identify the relationships within the system of real estate market
being modelled. Using the ARIMA model, these relationships become equations
in an interlinked system of equations.
While some property analysts use fundamental analysis to try to determine
the direction of the market trend, it seems that few can apply technical analysis
for timing their entry and exit from market positions. In general, fundamental
analysis is useful to gauge the long-term market factors, whereas technical
analysis is important for dealing with shorter-term influences.
Forecasting the real estate market is neither an easy task to accomplish nor
susceptible to naïve, mechanistic approaches. Nevertheless, any forecasting
approach that consistently provides better odds than those from tossing a coin
in making the correct investment decision should merit careful examination. In
fact, technical analysis has been developed and applied to finance for many
years, and this research will apply the Box-Jenkins methodology – ARIMA
model to the study of Hong Kong’s real estate prices. In a time series, it is
important to identify the data series in the following processes: (a) are the data
random?; (b) do the data have a trend?; (c) model identification and (d) testing for
model adequacy. If a series is random, the correlation between successive
values in a time series is close to zero. However, if the observations of time series
are statistically dependent on or related to one another, then the Box-Jenkins
(ARIMA) methodology is appropriate. By looking at autocorrelation
coefficients for time lags of more than one period, one can determine additional
information on how values of a given time series are related. This method
produces forecasts that are likely to be more accurate than the forecasts
produced by other approaches. The ARIMA models have also proved to be An application
excellent short-term forecasting models for a wide variety of time series of the ARIMA
because short-term factors are expected to change slowly. model
The simpler autoregressive and moving average models are actually special
cases of the ARIMA classes. Moving averages are popular for determining
turning points, that is when a market trend changes direction. The basic
concept behind application of moving averages is that, when a price series 153
crosses the correct moving average of itself, the price series will continue in the
direction of the crossing. Moving averages are also useful for filtering the effects
of cycles of known period in data. The simple models can contain either
autoregressive or moving average components but not both. A mixed
autoregressive and moving average model with both components is known as
an ARIMA model. This paper is the first to apply such a technical model in
studying the patterns of real estate prices in Hong Kong. The most important
practicality of the research is to show how to determine the cyclical turning
points in a real-estate price series. The model helps to track the direction of
changes in the real-estate prices.

The data
The data for this study are drawn from two sources: Property Review (various
issues), the Hong Kong Rating and Valuation Department and Hong Kong
Monthly Digest of Statistics (various issues). As the residential property market
in Hong Kong has been subject to government interventions, we will restrict our
attention to office and industrial properties. The main disadvantage of the data
is, however, the level of aggregation. The composite quarterly index for a
certain type of premises is simply compiled by calculating a weighted average
of the index for a property class or grade. Thus, the price indices can only be
regarded as providing a broad indication of the price trend. Aggregation tends
to result in an information loss. Moreover, there is an aggregate error arising
from the use of a common regression coefficient. As a consequence, the
forecasts obtained from disaggregated data are better in terms of mean square
error than those obtained from the aggregates. However, it is in any case
difficult to identify the most appropriate proxy for the price index in the real
estate market, since this heterogeneous sector includes different types and
classes of building, and demand for them is generated across all sectors of the
economy. Despite data limitations, there is some evidence in favour of a simple
averaging of the available data as a reasonable method of forming forecasts.
Above all Hong Kong’s properties are more homogeneous since multi-storey
development has remained predominant in the real estate market. It at least has
the merit of being a comprehensive measure. While ideal data on which to base
a study of future price trends are not available, an accurate indication could be
furnished. The price indices are based on an analysis of prices paid for
completed flats as recorded in Sale and Purchase agreements. The indices are
based on a rateable value for measuring price changes with quality kept
constant. Quarterly data for the period 1980Q1 to 1995Q2 which contains 59
Journal of observations, are employed in the ARIMA model. A 50-sample observations is
Property adequate for ARIMA analysis (Holden et al., 1990).
Finance The ARIMA model is essentially an approach to economic forecasting based
on time-series data. However, the ARIMA model requires the use of stationary
8,2 time-series data (Dickey and Fuller, 1981; Granger and Newbold, 1974; Tse,
1996). Under current practice, developing such data requires that the observed
154 data series should be tested for unit roots. The tests for unit roots are also
known as Dickey-Fuller (DF) and augmented Dickey-Fuller (ADF) tests.
Typically, the ADF test is based on the following formulation:

(1)

where ∆Yt = Yt – Yt–1, µ is a drift term and T is the time trend with the null
hypothesis H0: α = 0 and its alternative hypothesis H1: α ≠ 0, N is the number
of lags necessary to obtain white noise and ut is the error term. The simpler
Dickey-Fuller (DF) test removes the summation term. However, the implied t-
statistic is not the student t distribution, instead it is generated from Monte
Carlo simulations (Engle and Granger, 1987, 1991). Note that failing to reject H0
implies that the time series is non-stationary.
Generally, many kinds of non-stationarity are present in time series data. A
non-stationary time series is one for which the parameters are functions of time,
and thus one for which its mean, variance, and so on, change over time. A time
series is referred to as stationary when it contains no growth or decline and as
non-stationary when a trend is present. When a time series is non-stationary,
autocorrelations will dominate the pattern. To model the non-trend patterns in
the series, trends must be removed before further analysis can take place. The
most popular approach is to carry out consecutive differencing on the series
concerned to achieve stationarity and then fit the ARIMA model to them. In
fact, many time series can be made stationary by replacing the original data
points with their first differences; that is, the differences between successive
observations.
Since there is a strong upward trend in the series throughout the period, we
must therefore consider how to transform the data to remove this trend. It
seems sensible to deflate the data by Consumer Price Index in order to generate
a constant-price series. If the series is not deflated, it may have to be differenced
one more time to obtain stationarity. However, overdifferencing may introduce
unnecessary correlations into the model and cause information loss. Official
data are available up to the first quarter of 1996, but we only use quarterly data
in the period 1980Q1-1995Q2. The estimated equations will be used to forecast
for the next three quarters. There are two reasons for using quarterly data: first,
there are not enough annual data for performing an ARIMA analysis, and
second, annual data will average out aberrations that tend to distort the
estimation results in any given short span of time (there are no monthly data as
such in Hong Kong). Inflation rate in quarter j of time t (Ptj) is computed as
Ptj = (CPItj – CPI(t–1)j)/CPI(t–1)j, where CPItj refers to the Consumer Price Index- An application
A in quarter j of time t. Thus, real prices are discounted by the factor 1/(1 + Ptj). of the ARIMA
Let ROFF and RIND represent the real values of office and industrial property model
prices respectively. Table I reports the DF and ADF test statistics on the ROFF
and RIND in equation (1) omitting minus signs for simplicity. In Table I, the null
hypothesis of unit root for the ROFF in level form with and without time trend,
is rejected at all conventional levels of significance, but not rejected for RIND (at 155
the 0.05 level) when the calculated ADF test statistics associated with the
numerical coefficients of the variables are compared with their critical values, as
given in Engle and Granger (1987). It seems reasonable to carry out the analysis
assuming that the series of ROFF and RIND in level terms are non-stationary.
This implies that the properties of the series do not satisfy the usual
assumptions of econometric theory of constant mean and variance that,
conversely, evolve with time. The two series were first-differenced and the unit-
root tests re-run; in this form, the DF and ADF test statistics reject the
hypothesis of a unit root at all conventional levels of significance, suggesting
that the first differences of all the series under consideration are stationary.
Thus, the ARIMA tests were carried out in first differences of the data.

The methodology
The ARIMA technique does not assume any particular pattern in the historical
data of the series to be forecast. The applications of an ARIMA model are well
documented in Barras (1983), Box and Jenkins (1976), Chow and Choy (1993),
Cleary and Levenbach (1982), Hanke and Reitsch (1986), Herbst (1992), and
Nazem (1988) for example. An ARIMA model uses an iterative approach of
identifying a possible useful model from a general class of models. Another tool
for identification of stationarity in an ARIMA model is the ordinary and partial
autocorrelation. Non-stationarity may be present if the values plotted in the
correlogram do not diminish at large lags. When the original series or
correlogram exhibits non-stationarity, successive differencing is carried out

Level First differences

Variables Trend No trend Trend No trend

ROFFt–1 DF-0 lag 0.97 0.24 6.14* 5.92*

ADF-1 lag 1.40 0.72 4.22* 3.87*
ADF-4 lags 2.59 1.79 3.22 2.63
RINDt–1 DF-0 lag 1.23 0.74 6.33* 6.23*
ADF-1 lag 1.73 1.10 4.13 4.04
ADF-4 lags 4.02** 2.45 3.27 2.82
Notes: * and ** indicate significance at the 1% and 5% levels. The critical values of DF
statistics are: 3.5 with trend and 2.93 without trend, and 4.15 with trend and 3.58 without trend Table I.
at the 5% and 1% levels of significance respectively Results of unit-root tests
Journal of until the correlogram of the differenced series dies out reasonably rapidly. There
Property is a convenient notational device for expressing an ARIMA operation which
Finance relates a dependent variable to lagged terms of itself and to lagged error terms.
The general form of the ARIMA model can be written as:
8,2
(2)
156 where B represents the backshift operator such that BYt = Yt–1, Yt is the value
of the time series observation at time t, εt is a series of random shocks which are
assumed to be independently, normally distributed with zero mean and
variance and d represents the order of difference. If a series is stationary, then d
= 0. In equation (2), φ(B) is a polynomial of order p in the backshift operator B,
which is defined as:

(3)

Similarly, φ(B) is defined to be a polynomial of order q in B, such that:

(4)

The conditions for the existence of the model require (i) stationarity, that is the
statistical equilibrium about a fixed mean and (ii) invertibility, which
guarantees uniqueness of representation. While one may not be aware of the
appropriate order of the autoregressive process to fit to a time series, we
examine the time series of the property markets by taking differences of order 1
of the data. Once a tentative model has been selected, the parameters for that
model must be estimated. The first differences of the two series are given by:
(5)

(6)
Now, we shall proceed to estimating such a model. The ARIMA model is
generated iteratively by using the RATS program package until convergence is
obtained. The estimated parameters are shown as follows:
Office Property ARIMA(2,1,1)
(7)
Industrial Property ARIMA(2,1,1)
(8)
As seen, the lag structures of the two series are similar. Using equations (7) and
(8), the values of ROFF and RIND without error-correction terms (WET) which
are, respectively, ROFF^ and RIND^ can be estimated and compared with their
actual values (see Figures 1 and 2). The lag structure of the equations suggests
that the cyclical effects generated in the past information are transmitted
endogenously to current prices through the lagged variables. The
error-correction terms represent the random noise that tends to obscure the
true, fundamental movements of the market. It should be noted that there are
seasonal factors in a time series, which manifest themselves in the sample
autocorrelation function. Recognition of seasonality is important because it
provides information about regularity in the series that help make a forecast.

Figure 1.
Office property price

Figure 2.
Industrial property
price
Journal of We can identify seasonality by observing regular peaks in the autocorrelation
Property function, even if seasonal peaks cannot be discerned in the time series itself
Finance (Pindyck and Rubinfeld, 1991).
8,2 Estimation and forecasting
Generally, a comparison between the original time series and the estimated
158 model provides a measure of the model’s ability to explain the variability in the
original time series data. If the model is specified correctly, the residuals εt
should resemble a white noise. For a large displacements m, the residual
autocorrelation r k (k = 1,…, l) are supposed to be uncorrelated random
variables, normally distributed as N(0, 1/n) (Pindyck and Rubinfeld, 1991). The
model can be checked for adequacy by doing a diagnostic chi-square test,
known as the Box-Pierce test, on the autocorrelations of the residuals. The test
statistic due to Box and Pierce (1970) and modified by Ljung and Box (1978)
which is widely used today, is given by the formula:

(9)
where n is the number of observations used to fit the model, and l is the number
of autocorrelations included in the test, which is usually taken to be 6, 12 or 18,
m is the number of parameters estimated, and (l – m) equals degree of freedom.
This computed chi-square value can be compared against the corresponding
chi-square value from the chi-square table at a certain level of significance. If the
chi-square statistic does not exceed the threshold value, it can be concluded that
no recognizable pattern is left in the residual series and the model is not
rejected. The estimated values of the diagnostic Q-statistics for different lags
are summarized in Table II. Comparing the diagnostic Q statistics against the
theoretical chi-square values with corresponding degrees of freedom, it can be
concluded that none of these chi-square statistics is significant at the 0.1 level.
Thus the result suggests that there is no further pattern left in the residual
series of the estimated models.
From the modelling results described above, office and industrial property
prices in Hong Kong can be fitted into an ARIMA model. In the office and
industrial property sectors, it is user demand, rather than investment demand,
which is the dominant influence on real estate price trends, whereas in the
housing sector, investment demand appears to exert the strongest influence. If
investment demand is the dominant factor, speculators play an important role

Lag Office Industrial df Critical value (10%)

Table II.
6 1.99 2.16 1 2.71
The diagnostic
chi-square test: 12 5.14 11.15 7 12.02
Q-statistics 18 9.18 18.36 13 28.87
in the market. Their continuous buying and selling activities increase market An application
liquidity and transactions, although the housing market is subject to of the ARIMA
government interventions. However, if user demand is the dominant factor, a model
tendency to cyclical fluctuations in development will be created, corresponding
to alternating phases of relative undersupply and oversupply in the user
market. Thus, exogenously determined economic factors, such as construction
costs, the variation in user activity, and the terms and availability of credit will 159
all act on the inherent cyclical tendency, either reinforcing or dampening the
price trend according to circumstances (Barras, 1983). The changes in prices
can result from gradual shifts in demand and supply, and the interaction of
these economic factors is illustrated by the strong cyclical trend observed in the
office and industrial property prices.
In a perfectly efficient market, price at all times reflects the consensus of
value determined by sellers and buyers acting on their assessments of all
pertinent information. Thus, any new information will cause prices to change
quickly until a new consensus of value is reached, too quickly for investors to
profit from the news. The deviations from the path of real estate prices are as
likely to be positive as they are to be negative. However, the term “market
efficiency” must be hedged to some extent since it is unlikely that any market
could be so completely efficient that all prices adjust instantaneously to new
information. Above all, real estate markets are supposed to be of a lower degree
of liquidity than financial markets. Our forecasts will be based on the
assumption that the real estate markets are less than perfectly efficient. It
follows that the forecasts should be tempered by the observation that mass
psychology can influence market price behaviour in ways that can be traced by
an ARIMA model. The forecasting method can provide an indication of short-
term market direction, a sense of whether or not the movement will be small or
large, and a warning well ahead of turning points supplementary to investment
strategy.
The approach adopted is to assume that a causal model will help in
understanding behaviour and so will produce reasonable forecasts. With
further assumptions it is possible to make forecasts of future real-estate prices.
Suppose the estimation model is: Xt = f(Xt–1, Xt–2, …, Xt–L) + εt – θεt–1, for the
given values of X = {X1, X2, …, XT). The problem is to forecast Xt for t > T.
Since the expected value of the residual term should be zero: E(εt – θεt–1) = 0,
we assume initially that ε̂ T+1 = θεT. Therefore the estimated values ε̂T+2, ε̂T+3
… can be obtained. The forecasts: {X̂t , > T} can be generated as:
Journal of The corresponding predicted values of office and industrial property prices,
Property respectively, in the periods: 1995Q3 – 1996Q1 are illustrated in Figures 1 and 2.
Finance In order to verify whether these forecasts were profitable in practice, the
predicted values can be compared with actual figures. The forecasts which
8,2 yield a decrease of 18.3 per cent and 24.6 per cent in office and industrial
property prices during the period 1995Q3 – 1996Q1 are close to the actual
160 figures. Moreover, the direction of price changes is as expected.
Although the chi-square diagnostic tests do not indicate problems of mis-
specification, tests for structural breaks (using Chow test and Hendry’s
forecasting test) cannot be carried out in this research owing to data limitations.
Note that a sample of not less than 50 observations is required for an ARIMA
analysis. However, it should be noted that forecasts from an ARIMA model are
less susceptible to structural breaks. It is because the ARIMA procedure is an
adaptive process which can be started up at any point in a series. It recomputes
the regression while adding an observation to the sample. This means that the
regression will be updated, once the observation at time t + 1 is available.
Clements and Hendry (1996) argue that some models, such as the ARIMA
modelling, may offer greater protection against unforeseen structural breaks
than others. Moreover, in the presence of structural breaks, which occurred at
the time of forecasting, time-series models in differences tend to outperform
econometric models. An adaptive forecasting procedure like the ARIMA model
is expected to perform well in one-to-four-step-ahead forecasts.
One of the objectives of the ARIMA analysis includes improving the
accuracy of forecasts in real-estate prices. To measure the deviations of ROFF^
and RIND^ from their actual values, we can compute the root mean square error
(RMSE) of the naı̈ve forecast:
n
δ = [ (n – 3)–1 ∑ ( Z – Zˆ )2 ],
i =1

where Z = {ROFFi, RINDi}. Table III shows that the estimated equation of the
industrial property prices has a better fit compared with the office property
prices. For (n – 3) observations, the forecast accuracy can also be measured by
the Theil U-statistic which is defined as:
U = [ ∑ ( Z t + T – Zˆ t + T )2 / ∑ ( Z t + T – Zˆ t )2 ].
The U-statistic computes the ratio of the RMSE of the model forecasts to the
RMSE of naïve, no-change forecasts (Dua and Ray, 1995). This statistic implies
that:
(1) U = 1, the model’s forecasts match, on average, the naïve forecasts;
(2) U < 1, the model’s forecasts outperform the naïve forecasts;
(3) U > 1, the naïve forecasts outperform the model forecasts.
Thus, a model producing a lower average U-statistic has a relatively better
forecasting accuracy. Table III reports the U-statistics for the office and
 δ µa σ µ/σ µg/σg

Office
80/1-82/4 159.3 17.2 9.27
80/1-85/4 120.9 41.2 2.93
80/1-88/4 121.5 40.8 2.98
80/1-91/4 159.4 74.9 2.13
80/1-95/2 24.7 199.4 175.4 1.38 0.26
Average U 0.416
Industrial
80/1-82/4 138.8 19.7 7.06
80/1-85/4 119.5 24.3 4.91
80/1-88/4 129.1 34.1 3.79
80/1-91/4 164.4 68.5 2.40
80/1-95/2 16.7 224.1 127.3 1.76 0.35
Average U 0.410
Notes: The risk-adjusted price performance µ/σ = √{1/(ΣZ2i/(nµ2) – 1)}
Table III.
µg = Σzi/(n – 1) and σg = √{Σ(zi – µg)2/(n – 1)}, where zi = log(Zi/Zi–1) Average performance of
a First quarter of 1980 = 100
real estate prices

industrial properties. It indicates that the industrial-property model provides a

slightly better performance relative to the office-property model.
Furthermore, the forecasting performance can be gauged by comparing the
RMSE (δ) with the mean value µ: we obtain δ/µ of 12.4 per cent for office and 7.5
per cent for industrial property. Accordingly, we suggest that a turning point is
likely to occur when the reversed change in prices is greater than δ/µ. Using this
criterion, the results correctly indicate that the movements of the office and
industrial property prices changed directions in 1994. To compare the average
performances of the property prices, we compute the mean values ( µ) and
standard errors (σ) of their nominal prices with moving time periods (Table III).
Thus, µ measures the average price performance, and σ measures the
associated risks. The risk-adjusted price performance which is equal to µ/σ, is
better in office than industrial property in the period 1980Q1-1982Q4. Moreover,
the office property performs better than industrial investments in terms of
return and risk in that period. However, in the longer term, it turns out that
industrial property is better than office investments. As shown in Table III, the
risk-adjusted price performance of industrial property is 1.76, which is
significantly much higher than that of office property at 1.38. When the mean
value of rate of price change (µg) is compared with its deviation (σg) in the whole
period 1980Q1-1995Q2, the risk-adjusted price change (µg/σg) of the industrial
property is 0.35, which is also significantly better than that of office at 0.26.
Journal of Conclusions
Property The technical analysis presented in this paper provides sufficient evidence in
Finance support of the adequacy of the estimated models for office and industrial
properties in Hong Kong. In fact, the behaviour of real estate prices has long
8,2 been a matter of interest. Technical analysis was built on the belief that human
mass behaviour over the centuries has exhibited a tendency to move in trends
162 (Flood and Hodrick, 1990). Such psychological factors are probably considered
to fuel shorter-term cycles in financial and futures markets. This paper
concentrates on an analysis that attempts to fit real estate prices in Hong Kong
into the ARIMA model. This paper shows how the office and industrial
property prices in Hong Kong can be fitted into the ARIMA equation.
The core of the ARIMA model is premissed on the fact that the market price
at any time is revealed by the pattern of prior price movements. While
fundamental analysis suffers from the problems of model building, technical
analysis suffers from problems related to pattern validation. Changes in
fundamental factors can of course alter prices. However, as far as the property
market is concerned, these changes are unlikely to cause gradual shifts in
consumer tastes and preferences or conversion to substitute or complementary
products. It should be noted that technical analysis is inadequate at signalling
market turning points in the longer term. Property price trends may fade
because of fundamental economic causes, effectively reducing the predictive
power of the technical analysis. Thus it has already become an accepted
practice that ARIMA models and econometric models can be combined to give
an improved forecast. While econometric methods are not always more accurate
than time-series models, they help in understanding causal relationships
between variables and can provide evidence of the validity of economic theory.
Moreover, all forecasting methods require the use of qualitative judgement.
Simple methods based on sound judgement frequently give better forecasts
than complex and sophisticated methods (Holden et al., 1990). Thus, a point
forecast is of limited use and tends to be associated with uncertainty (Granger,
1996). More attention could be paid to how forecasts are to be used, since the
purpose of forecasting is to help in investment decisions. We do not suggest an
ARIMA methodology is used to provide a forecasting model directly without
resort to other procedures. If forecasts from a technical and behavioural model
can be combined to give an improved forecast, this suggests that each of these
models is inadequate if used independently. A better forecast might arise from
a union of the two models. However, the investor may wish to incorporate
forecasts from an ARIMA model into his investment strategy, to help with
timing.

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