By: Phil Kernen
Prices are rising. In November, according to the Consumer Price Index, the cost of living increased 6.8% from last year, the fastest annual increase seen since the early 1980s. The Federal Reserve is finally abandoning the idea that growing inflation will quickly ease as we exit the pandemic. Inflation is here to stay and may worsen due to one impactful factor yet to take root in the official data – the cost of shelter.
Throughout 2020, apartment vacancies climbed as many Americans moved in with families, left for places seen as less crowded, or hit the road altogether. Many renters in major metropolitan areas took advantage of discounts and price reductions as landlords struggled to fill empty units. That is changing now. As we learn to live with COVID, those former renters are returning and are finding an unwelcome surprise. Vacancies are lower, and rents are higher than when they left.
As with so many other industries, rapidly shifting demand has overwhelmed supply. According to a recent report from Apartment List, rent growth in 2021 was higher than ever. The national median rent is 10% higher than what it would be if growth rates from 2018 and 2019 had continued.
Addressing inflation in shelter costs for owner-occupied homes is more complicated. The Bureau of Labor Statistics imputes rental expenses by determining how much you would pay to live in your home if you didn’t own it. It is called owner’s equivalent rent (OER). The methodology makes quality adjustments but does not consider housing price changes as sales occur. Nevertheless, a relationship exists between housing prices and their effect on the OER inputs used for CPI.
As rents increase, the methodology behind OER eventually accounts for the changes. However, it is not 1-to-1 and often shows up with a lag as surrounding rents adjust. Estimates from the Federal Reserve Bank Branch of Dallas suggest that the lag between higher home prices and higher OER is under two years. Housing prices accelerated when the pandemic began, and those growth rates only now appear to be moderating. According to the Federal Finance Housing Agency, U.S. house prices rose 18.5% from the third quarter of 2020 to the third quarter of 2021.
Rent and OER are among the most heavily weighted components of CPI, representing 24% of the index. By comparison, the two most unpredictable contributors to CPI, food and energy, together represent only 21%. Energy prices alone can quickly move 50% in either direction, so inflation predictions based on energy prices are highly unreliable. Shelter inflation is different. When using core CPI, which removes volatile food and energy prices, the shelter weight increases to 30%.
In addition, rents are sticky, whose averages change slowly and adjust gradually. Throughout the pandemic, CPI shelter costs have steadily increased between 3.0 – 3.5% annually, not far from the average recorded over the prior decade. Changes to shelter costs in November rose 3.8% from last year. We expect them to continue increasing.
Supply will eventually meet the demand in housing, but it will take a long time. Creating an inventory of new housing is a slow process. Doing so is a function of local limitations on land, labor, and materials. Further, according to a report written for the National Association of Realtors (NAR), housing over the last decade has been underbuilt. For example, from 1968 – 2010, housing stock grew at an average annual rate of 1.7%. It grew by 0.7% over the last decade. From 1968-2020, residential investment accounted for 5% of GDP. Since 2008, it has dropped to only 3% of GDP. By the NAR estimates, we are short by 5 – 6 million homes. Compared to the average 1.5m homes constructed each year, catching up will be a long process, and rent pressures will keep overall inflation elevated.