Almost Everyone Looks at Inflation Wrong: BGO Economist

“Inflation came in hotter than expected.”

It’s probably not the first time you’ve heard these words, and given the state of inflation indicators, probably not the last.

“But it isn’t rising nearly as quickly as that data indicated,” wrote BGO chief economist Ryan Severino. “The rate occurred due to the shelter component of inflation.”

The shelter component has irritated Severino and many others in CRE for some time. Here’s the essence of the problem: Start with a circular mechanism that has been working to keep inflation higher and property investors unhappy for some time:

1. During the pandemic, a lot of new money from investors seeing virtually no return from such investment areas as fixed income and private lending moved into commercial real estate, including multifamily.
2. The flood of money acted as a supply in bidding for properties. Prices rose and cap rates dropped. Investors, including in multifamily, had to ensure enough future rent increases to make their deals work.
3. Apartment rents, as well as the rent equivalents for homeowners that are part of the shelter portion of the Consumer Price Index calculation, kept increasing.
4. Shelter became a major ongoing contributor to higher inflation.
5. The Federal Reserve sharply and quickly increased interest rates to battle inflation, assuming they were mostly a product of general product and service demand.
6. Higher Fed rates meant higher CRE borrowing, making refinancing and new development and purchases even more expensive, requiring higher forward-going rents.
7. The higher rents meant bigger shelter increases, which resulted in higher interest rates to battle inflation and started the whole cost increase cycle again.

In particular, Severino objects to the calculation of owners’ equivalent rent (OER). “The problems with OER consequently cause problems with overall inflation because OER represents 27% of CPI,” he wrote. “Rent for apartments represents about 7% and gets calculated on a more straight-forward basis.”

There are five problems that he and others see.

• The OER number is arbitrary because it’s calculated by asking homeowners how much it would cost to rent their own home today, and they don’t have the necessary research materials to know. “We recently polled a large number of CRE professionals and even they did not know,” Severino wrote. That’s a bad sign. Maybe citing the mortgage cost would be more realistic, though that would be zero for 40% of homes in the U.S., according to Severino.
• No one actually pays this amount. This is the rough equivalent to businesses calculating opportunity costs. You might use the number to consider where to better invest going forward, but it doesn’t represent an actual cost. And if it were frequently cited, you’d think the company would get out of the business it had been in and do something else.
• Severino also argues that homeownership is really an investment, not a consumption good, and shouldn’t be treated as such. Well, maybe. There’s also an argument that if you have to pay to live someplace, a portion of what’s paid should represent some form of consumption. But maybe not all, unless inflation will start including as a “cost” retirement savings.
• OER is a backward-looking metric as it only acquires batches of data every six months, creating two problems. One is inaccurate information “because the BLS simply performs a straight-line interpolation between observations, and we know that’s not how housing markets behave,”  Severino wrote. The other problem: the information is stale. Currently, it makes shelter costs seem higher than they are, which isn’t good for steering an economy.
• The U.S. is the only advanced economy that uses this method. “If the US used the same harmonized method, the year-over-year US CPI would be 2.2%, far below the current 3.8% and basically at target,” he wrote.

In an extended closing, Severino stressed that these practices are unnecessarily prolonging higher interest rates for perhaps no good reason and, thus, preventing full recovery of CRE financing.

He also added that the numbers skew understanding of housing markets, which would still “offer attractive long-term investment prospects, even if prices and rents aren’t growing nearly as quickly as the BLS would like everyone to believe.”