Owner-equivalent rent unmasked

We all need a place to live and the price that we pay for rent in most areas of the country can lead many to seek homeownership to build up our investment portfolios. But the truth of the matter is whether we rent or own a home we always have a watchful eye on how much of a bite the cost of shelter is taking out of our paychecks. The reality is that shelter makes up about one-third of the total Consumer Price Index (CPI) basket, and an even greater share of core inflation (ex-food and energy). Digging deeper, shelter inflation has accelerated faster than overall core inflation over the last few years. But, it’s lost momentum in recent months. On a quarter-over-quarter annualized basis, shelter inflation has declined from 4% as of October to 2.6% as of May. However, shelter inflation, specifically owner-equivalent rent (OER) has limitations.

Calculating shelter inflation

Shelter’s 33% weight, or relative importance with in the CPI, is broken down into rent, at 7.5% and to something called owner-equivalent rent (OER) at 24.4%.[1] Rent is an obvious concept but OER isn’t. You might assume that statistical agencies want to measure home prices. But, homes are capital goods, not consumption goods. Statistical agencies want to capture the consumption component of housing, or how much a home owner would be paid for renting out their house. That’s OER! In fact, to derive OER, the Consumer Expenditure Survey, asks home owners, “If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished, and without utilities?”

OER inflation tracks rents closely. The rub is that rental inflation doesn’t move around much, it’s “sticky.” The longer tenants stay in apartments, the less likely their rents increase. This lack of volatility hides significant cyclical movements in home prices. Economist Adam Ozimek suggested the CPI did not accurately capture the housing bubble and bust. [2] In the mid-2000s, home price inflation peaked out at between 17% (using the S&P Case Shiller Index) and 12% (using the FHFA data), but OER rent topped out at 4.5%. The bust led to 20% declines in home prices year-over-year (using Case Shiller data), but OER barely registered a decline. Economists who paid attention to relatively benign OER inflation ignored the rapidly overheated housing market to their peril.

In addition, the relationship between home prices and OER is not straight forward. The correlation is pretty weak. Atlanta Federal Reserve economists Mike Bryan and Nick Parker parse out why. They think that OER is related to home prices in two ways.[3] First, there is the asset market influence, as the value of the home increases, landlords want raise rents accordingly. But, there is also a substitution effect, as rents increase, tenants switch to homeownership, leading to less demand for rental housing and lower rents. Long-term trends in OER and home prices are highly positively correlated. But, de-trended series are negatively correlated likely reflecting the substitution effect.

Fast forward to today, economists are concerned about the weakening core inflation numbers over recent months. Indeed, waning rent and OER price changes constrained overall inflation. However, OER doesn’t accurately capture the health of the housing market. Home prices may capture the cyclical trends more effectively. In addition, rents may be declining as tenants switch to homeownership. Homeownership rates, while still low, have picked up since bottoming in early 2016. OER is a big component of CPI-based inflation measures, but don’t let its outsized impact mask its limitations!

[1] Using May 2017 weights.

[2] Ozimek, Adam, Sticky Rents and the CPI for Owner-Occupied Housing, January, 2014.  Ph.D. Dissertation

[3] http://macroblog.typepad.com/macroblog/2013/03/you-say-youre-a-homeowner-and-not-a-renter-think-again.html



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