Independent Investment Advice Blog

Will housing distort the CPI? Independent investment advice

The Consumer Price Index (CPI) has 40% of its weight influenced by the cost of renting, used as a proxy for the cost of home ownership. The risk is that inflation statistics may be distorted by housing costs. Have a lot of experience with real estate finance, so I like to discuss this issue. One way of looking at it is to assume that a huge mass of unsuccessful home owners will go into foreclosure and become renters thus increasing demand for rental properties and thus creating inflation. The deflationists would argue the opposite: that a flood of foreclosed home may result in them being sold to investors and the investors will be forced to compete to recruit tenants with ever-declining rents. My view point is that these two forces may cancel each other out so that “owners equivalent rent” used to calculate CPI will be roughly zero change, and this non-inflationary event is fair to blend into the CPI. Another way of looking at it is to imagine an island with 9 poor home owners who go into foreclosure and one rich family who buy the foreclosed homes and rent them. The demand for rental units has increased, but so has the supply, thus no net change in rents should occur. However, some homeowners may be foreclosing on and vacating a 2,500 square foot home and seeking to become a tenant in a 1,000 square foot home so as to save on rent. This would also become an inflation neutral event because it would cause rents to decrease for large homes but go up for small homes so that the price changes at the two ends of the spectrum would balance out each other. However, large homes could be divided into duplexes and rented out, thus increasing the supply of lower cost, small rental units, thus hinting at a slight deflationary aspect of the “owners equivalent rent” used to calculate CPI. The big picture is that U.S. consumers will be dealing with deleveraging and repairing their damaged retirement funds, etc. so they need to reduce their standard of living which implies a drop in housing expenses as the number of home buyers is reduced and house prices continue to decline. If house prices decline by 2 to 3% a year for five years this would eventually filter through to CPI and if a 2.5% rental cost decline is weighted by 40% in CPI then that shaves a whole percent off CPI each year for several years. Assuming that the Gross Multiplier (a ratio of rent per year to property value) for housing stays the same and sales prices for houses drop then new landlords will charge less for rent than existing landlords. I have written about housing here and here. This is an example of independent investment advice.