Shelter Inflation to 'Slow Significantly' Says San Francisco Fed

Multifamily, single-family rental, and build-to-rent property types find themselves in an uncomfortably ironic crossroads today.

On one hand, the growth of shelter costs — housing and rental asking prices —helped grow property valuations and rents since the onset of the pandemic at an unusually high pace, increasing NOIs and pushing down cap rates.

On the other hand, that shelter costs growth has been a major driver of the very inflation that ultimately caused the Federal Reserve to increase interest rates as a way to cool the economy. A byproduct has been higher CRE financing rates that have made refinancing for many next to impossible.

The same costs that helped hike inflation up a bit last month, as the Bureau of Labor Statistics said in the Consumer Price Index Summary: “The index for shelter was by far the largest contributor to the monthly all items increase, accounting for over 90 percent of the increase, with the index for motor vehicle insurance also contributing.”

So long as shelter costs keep rising, the CRE industry is largely in the position of heavily contributing to an industry problem that has already helped undermine valuations.

That is what makes new research out of the San Francisco Federal Reserve Bank a good news-bad news scenario. Researchers Augustus Kmetz, Schuyler Louie, and John Mondragon wrote that “shelter inflation is likely to slow significantly over the next 18 months.” The forecast models making the prediction are using different measures of local shelter and rent inflation to understand how current trends might affect the future.

The bad part for multifamily developers, investors, operators, and owners is that rental rate growth would slow, which is not good for immediate NOI. The good part, if pressure comes off, the Fed might eventually start lowering interest rates, leading to better overall conditions for the industry.

The economic picture is complex and “how much inflation pressures have moderated depends significantly on the impact of shelter inflation, which has been above 8% since early 2023,” the researchers wrote. But rents do not move evenly across all markets. The CPI includes households that have been in the same apartment for an extended period of time and others that have recently moved and might be paying prevailing asking rents.

For a better forecast, they also used data from Zillow, Apartment List, CoreLogic, S&P/Case-Shiller, and past CPI shelter data. “Our baseline forecast suggests that year-over-year shelter inflation will continue to slow through late 2024 and may even turn negative by mid-2024,” they wrote. “This would represent a sharp turnaround in shelter inflation, with important implications for the behavior of overall inflation.” That would be “the most severe contraction in shelter inflation since the Global Financial Crisis of 2007-09.”

A second model that removes the most negative effect, lagged CPI shelter information, doesn’t see a deflationary period in 2024, but still shows significant slowing during the next 18 months.

“Whether shelter inflation remains high will strongly influence the path of future overall inflation because shelter makes up about 30% of the CPI consumption basket,” they wrote. And, by logical extension, the path of future interest rates and financing challenges.