We recently bought a summer house for our family on the Jersey shore. This was not a unique impulse on our part – it is a seller’s market in the worst way imaginable. Having begun our search calmly with no intention of being rushed, we were soon in a bidding war which we “won” — by exhibiting less financial self-discipline than anyone else involved. Within weeks and before we’d closed, our realtor reported that we could assign our contract to another buyer for almost a 10% gain over our price. Bedrooms had already been assigned and additional beach equipment purchased. A quick taxable gain wasn’t enough to counter the prospect of long family faces. Suburban real estate outside New York and many other cities is hot.
Naturally my thoughts turned to Owners’ Equivalent Rent (OER) — the quixotic means by which the government measures housing inflation. Historically, around two thirds of U.S. households own their home (it’s currently 65.8%). Around a quarter of consumer pre-tax income is spent on housing (either owned or rented). Measuring rental inflation is done by surveying actual rents, but for owner-occupied housing, the Bureau of Labor Statistics (BLS) conducts a phone survey in which they ask, “If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?” This is OER.
A house (or an apartment) is a physical asset that provides a service (shelter). The BLS wants to measure the value of the service not the cost of the asset. It’s a sound theory — except that few homeowners spend much time considering the rent they could charge if they vacated their home. OER is a theoretical concept – the only element of the inflation statistics not supported by actual prices.
These are familiar criticisms for those who have studied the issue. BLS statisticians argue that OER reflects all the costs of home ownership, including property taxes, mortgage expense and maintenance, just as the rental cost of an automobile or airplane does. They also argue it’s also not easy to identify an alternative – an index that included mortgage expense and property taxes would incorporate the cost of financing an asset, which they’re not trying to measure.
No cash changes hands based on OER and if it rose sharply, therefore driving inflation higher, would it even matter? The Fed would likely dismiss it as unimportant, a non-cash item. And they’d be correct to. Hiking interest rates because perceived rental income was rising even though nobody was paying those higher rents would seem ludicrous. But since conventional inflation statistics omit the actual cost of shelter incurred by homeowners, the result is that inflation in the biggest portion of consumption expenditures for two thirds of U.S. households is not picked up.
In recent years, OER has lagged the Case-Shiller U.S. National Home Price NSA Index (C-S). Prior to 2000, OER supporters could argue that since OER was tracking C-S it was working, even if their close relationship seemed coincidental given their different methodologies. But since 2000 OER and C-S have deviated, and the gap has steadily widened, as noted in this blog post. Prior to the 2008 financial crisis, OER didn’t show any housing inflation even while actual home prices soared and then slumped. Through December (most recent C-S data), house prices are up 10% year-on-year nationwide, while OER has registered only 2%, less than the five-year average. The most recent OER for February showed a 2% year-on-year increase. Over the last decade, house prices have risen more than twice as fast as OER.
OER doesn’t work.
Most households obtain shelter through buying a home. It’s obvious that house and apartment prices determine the cost of shelter for most of the population, even if buying shelter also requires buying an asset. For the past three decades, the U.S. home ownership rate has remained between 64% and 69%. It’s not that sensitive to prices – many households deem ownership as the only acceptable way of obtaining shelter. Although the BLS statisticians would like us to think of shelter (a service) as separate from an asset (a house or apartment), that isn’t how Americans think. The BLS simply isn’t measuring the cost of shelter in a meaningful way. OER is a flawed concept.
The cost of shelter has risen far more than the 2% suggested by OER over the past year. Using house prices, inflation is really 1% or so higher than reported, even using the Fed’s preferred Personal Consumption Expenditures (PCE) index, which weights OER at 15%. CPI, with a higher OER weighting, would be at least 2% higher. A more representative index would confirm what we already know — inflation is rising.
Because it would make sense to ignore a rise in OER, as it’s a theoretical non-cash expense, and since the Fed doesn’t consider actual home price inflation that affects two thirds of households, it means that inflation in the cost of shelter never impacts monetary policy. A housing bubble led to the 2008 financial crisis, so this is a serious omission that has had negative consequences before. It may again.
It’s often suggested that the government has an incentive to under-report inflation – many transfer payments including social security are indexed. The return on TIPS relies on inflation. Higher inflation automatically drives increased Federal outlays, worsening the fiscal outlook. A government conspiracy to manipulate the numbers is implausible – but it’s also easy to imagine that a junior economist at the BLS contemplating a paper on the weakness of OER might conclude better career moves are available.
Today’s inflation numbers don’t fully reflect the experience of most Americans. It’s time the BLS adopted a more realistic approach.
We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.
The information provided is for informational purposes only and investors should determine for themselves whether a particular service, security or product is suitable for their investment needs. The information contained herein is not complete, may not be current, is subject to change, and is subject to, and qualified in its entirety by, the more complete disclosures, risk factors and other terms that are contained in the disclosure, prospectus, and offering. Certain information herein has been obtained from third party sources and, although believed to be reliable, has not been independently verified and its accuracy or completeness cannot be guaranteed. No representation is made with respect to the accuracy, completeness or timeliness of this information. Nothing provided on this site constitutes tax advice. Individuals should seek the advice of their own tax advisor for specific information regarding tax consequences of investments. Investments in securities entail risk and are not suitable for all investors. This site is not a recommendation nor an offer to sell (or solicitation of an offer to buy) securities in the United States or in any other jurisdiction.
References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and do not reflect the deduction of the advisor’s fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase. Indexes and benchmarks may not directly correlate or only partially relate to portfolios managed by SL Advisors as they have different underlying investments and may use different strategies or have different objectives than portfolios managed by SL Advisors (e.g. The Alerian index is a group MLP securities in the oil and gas industries. Portfolios may not include the same investments that are included in the Alerian Index. The S & P Index does not directly relate to investment strategies managed by SL Advisers.)
This site may contain forward-looking statements relating to the objectives, opportunities, and the future performance of the U.S. market generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involves a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of SL Advisors LLC or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made. r
Certain hyperlinks or referenced websites on the Site, if any, are for your convenience and forward you to third parties’ websites, which generally are recognized by their top level domain name. Any descriptions of, references to, or links to other products, publications or services does not constitute an endorsement, authorization, sponsorship by or affiliation with SL Advisors LLC with respect to any linked site or its sponsor, unless expressly stated by SL Advisors LLC. Any such information, products or sites have not necessarily been reviewed by SL Advisors LLC and are provided or maintained by third parties over whom SL Advisors LLC exercise no control. SL Advisors LLC expressly disclaim any responsibility for the content, the accuracy of the information, and/or quality of products or services provided by or advertised on these third-party sites.
All investment strategies have the potential for profit or loss. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client’s investment portfolio.
Past performance of the American Energy Independence Index is not indicative of future returns.