In the world of real estate investment, a nuanced understanding of how rent is measured in the Consumer Price Index (CPI) is crucial. The CPI, a fundamental economic indicator, plays a pivotal role in shaping inflation calculations, policy decisions and, consequently, the real estate market.
A recent paper from the Cleveland Fed explores the nuance of recent rental rates vs. all rental rates used in the CPI and how this may impact inflation forecasts by giving an earlier insight into the direction of rental costs.
Understanding the CPI and its significance
The CPI is a primary economic indicator influencing essential financial and policy decisions. Within the CPI, shelter costs, encompassing rental and owner-occupied housing, constitute about 32 percent of the index, with rental costs encompassing 8 percent of the CPI.
The CPI currently employs the owners’ equivalent rent (OER) method, focusing on the rent growth faced by all occupants. This all-encompassing approach aims to reflect the average renter’s experience, thereby representing broader economic conditions.
The current CPI methodology: An all-tenant perspective
The CPI’s all-tenant approach includes rents from both long-standing and new tenants. This methodology is designed to capture the general trend in rental prices, offering a stable and comprehensive perspective over time.
It accounts for the rent changes that the average renter, not just the new entrants to the rental market, would experience. This approach provides consistency and continuity, essential for long-term economic planning and policy formulation.
Proposed changes: Focusing on new-tenant rents
Contrasting the current CPI methodology is the proposal to focus on new-tenant rents. This approach, highlighted in the Cleveland Fed article, suggests exclusively considering the rent changes for tenants who have recently moved in. Advocates for this approach argue that it better reflects the current market conditions, capturing the immediate dynamics of the rental market.
For instance, in 2022, the all-tenant repeat-rent (ATRR) index showed a year-over-year inflation of 6.73 percent, while the new-tenant repeat-rent (NTRR) index indicated an 11.95 percent inflation rate, demonstrating a significant discrepancy from the CPI’s recorded 5.14 percent.
Analyzing the implications of new-tenant rent measurement
Adopting a new-tenant-focused approach could offer a more immediate and responsive view of the rental market. This method might provide real-time insights into market trends, rental demand, and pricing dynamics, which are especially relevant in rapidly changing or volatile markets.
However, it also presents challenges, primarily the lack of representation of the broader tenant population’s experience. A new-tenant index could fluctuate more significantly, leading to a less stable and potentially misleading representation of the overall rental market trends.
Practical considerations for real estate investors
Understanding these methodologies is critical for real estate investors who generally have a long-term perspective. While new-tenant rent indices may offer insights into short-term market trends, the all-tenant approach used in the CPI provides a more stable, long-term view of the rental market.
Investors should weigh these aspects when making investment decisions, analyzing market trends, and developing investment strategies. Comprehending the nuances of these rent measurement methodologies can lead to more informed investment choices and better anticipation of market shifts.
Importantly, many investors and would-be buyers are sitting on the sidelines, paralyzed by current interest rates. No one can ever know what interest rates will do in the future; however, thinking critically about the components of the CPI and which elements may lag in time can give investors some indicators of inflation rates in the future for their portfolio planning purposes.
We always encourage our clients to make their guesses about the direction of interest rates, as it is always truly just a guess.
Navigating the future: A balanced perspective
The ongoing debate on rent measurement methodologies in the CPI underscores the need for a balanced perspective that considers both immediate market dynamics and long-term trends.
Real estate investors must stay informed and adaptable, recognizing that the choice between the current all-tenant approach and the proposed new-tenant focus reflects different market dynamics and inflation measurement perspectives. Navigating these complexities is crucial for developing robust investment strategies in the evolving real estate market.
From the man-on-the-street economic perspective, we have seen a sharp increase in rental rates in Austin, Texas, in 2021/2022 and just as quickly a steep decline from 2022 into 2023. Given this recent volatility in rental rates, it resonated that a metric focusing on recent rental rates may give some insight that long-term measurement may miss.
Without this recent volatility, we may not have seen the need for a metric that tracks changes over such a short time.
As the real estate landscape evolves, so does the importance of understanding the intricacies of rent measurement in the CPI. Whether the CPI adopts a new-tenant-focused approach or retains its current all-tenant methodology, the understanding of the nuance of the different measurements is important for investors looking into the future and guessing where they think interest rates may be headed.
If, in fact, newer renters are paying lower rates, real consumer costs may be lower than currently thought, meaning real inflation may also be lower, driving the Fed to ease monetary policy sooner.
Jen Berbas is the team lead of the Berbas Group in Austin, Texas. She transitioned from a long career as a statistical arbitrage trader to a role in operations, where she discovered her passion for using processes to improve client experiences. Connect with her on Instagram and Linkedin.