On CPI and Owners Equivalent Rent

I noticed this story on Owners Equivalent Rent on the Atlanta Fed’s blog today.  It discusses the rationale behind using what the Bureau of Labor Statistics calls “Owners Equivalent Rent” in their CPI calculation.   Specifically, they say:

“This begs the question: In light of the recent strength seen in the housing market—and notably the nearly 10 percent rise in home prices over the past 12 months—are housing costs likely to exert more upward pressure on the CPI?

Before we dive into this question, it’s important to understand that home prices do not directly enter into the computation of the CPI (or the personal consumption expenditures [PCE] price index, for that matter). This is because a home is an asset, and an increase in its value does not impose a “cost” on the homeowner.”

The BLS says housing is not consumption, but investment so they don’t include it in the CPI calculation.  They rationalize this thinking by stating not only that housing “does not impose a ‘cost’ on the homeowner”, but also that “House prices frequently appreciate; in this respect they differ from consumer durables such as vehicles.”  These two statements are highly misleading.  Let me elaborate.

First of all, most houses are definitely depreciating assets.  From the second you build a new home someone else is building the same home with more innovative and updated technologies.  The primary reason why homes don’t decline in value is because the land appreciates in value and the home is frequently updated (in addition to other reasons).  This is a real cost to the homeowner over the life of the house.

The other substantial cost in “owning” a home is the mortgage.  Most of us do not buy our homes outright and the mortgage imposes a massive cost on the homeowner.  The word mortgage is derived from the latin meaning “death contract”.  Not only is mortgage debt the largest portion of consumer debt (approximately 75% of all debt), but it also accounts for about 75% of the cost of the home over the life of a standard 30 year mortgage (ie, you will pay about 75% of the cost of the home in interest ALONE over a 30 year period).  In other words, a mortgage is a lot like consuming your home bit by bit.  Taken together, the mortgage and the upkeep of homeownership are substantial costs that most people simply don’t include in their total return calculations of real estate prices leading them to say silly things like “house prices frequently appreciate”.    But the BLS completely ignores this by using their Owners Equivalent Rent calculation.

This was clearly a problematic view during the last 10 years when the real cost of a home caused huge problems for the economy as mortgage resets were one clear cause of the balance sheet recession.  Had we been paying more closely to house prices we might have noticed a disequilibrium in the economy a bit sooner than we did.  But the Fed and the BLS were focused largely on OER and thus a benign looking CPI reading.  My adjusted housing price index is far from perfect, but were we using something like this in conjunction with the CPI I think we would have had a much clearer picture of the potential problems in the economy and the supply imbalances that were potentially creeping into the housing sector.  Instead, this flawed view of the consumers most important asset price helped lead us blindly right over a cliff.

(Chart via Orcam Financial Group)


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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • LVG

    But housing wealth effects end well? Don’t they? Isn’t that what we should really be focused on?

  • http://www.orcamgroup.com Cullen Roche

    Yes, you’re right. Never mind what I wrote here.

  • Geoff

    Good post. Housing isn’t an investment in any case. One might call it a place to allocate savings ;) but even that’s a stretch.

  • Ilya

    The wealth effect is very real. My real estate taxes and insurance keep going up as my house appreciates. I feel the effect :). Then again I am not borrowing against it. So unamerican of me.

  • Rich R

    Very true about home values often being a function of location….in Cherry Creek, Denver and many other areas I’m sure, it’s not unusual for a wealthy purchaser to purchase a home and tear it down…then build another one in it’s place.

  • VictorC

    Let’s be honest. The BLS changed the CPI because they didn’t want housing prices to cause the index to appear higher than it really is. This way we can all talk about how “log” inflation is. BS.

  • VictorC


    -edit button please.

  • Hoffa

    I agree, however, the Fed can not use the cost when they target inflation because then increased interest rates increase user cost, and hence inflation. If a central bank raise interest rates because house prices is increasing one might cause deflation in every other component of the CPI to hit the inflation target. Seems to me it is hard to find an index without some flaw in it.

  • Steve W

    Good post, Cullen. My sister’s step-daughter bought a house a few months ago. I remember asking my sister if the young lady needed to rush out a buy a house (because after all, she’s a single mother of two, barely out of nursing school a about six months in to her first full time nursing job). The predictable response: interest rates are low and why should she pour all that money down the drain by renting? The young lady will learn fairly soon about the costs of maintenance, etc. Her property taxes and insurance are escrowed, so it’s all about the monthly payment now.

    There are valid reasons to buy a house, but it’s almost always a mediocre, if not poor investment — unless one catches a rapid appreciation cycle.

  • Geoff

    Using mortgage rates in the CPI would be problematic because inflation drives interest rates. It would be a circular disaster.

  • Johnny Evers

    Housing is a bad investment, but owning your own home outright is a huge cash flow benefit and protects you from property inflation.

  • http://www.orcamgroup.com Cullen Roche

    Yeah, I think the big thing is understanding that there are components of both consumption AND investment in housing prices, but the BLS makes it too black or white. I don’t think my index is perfect, but I do think it would have set off some warning signs early on. It also would have triggered the deflation risk much sooner than it actually came….This index guided a lot of my thinking during that period which is why I think I got it a bit more right than a lot of other people.

  • GLG34

    Wait, does this mean you’re not a Fed informant? I was convinced you were.

  • Oilfield Trash

    I think if I was on SS I would be wondering what I gave up in COLA adjustments with CPI using OER during the housing boom.

    Macroeconomic automatic stabilizers??

  • Not an Economist

    “Housing is a bad investment…”

    Why? What makes an investment “good”?

  • Geoff

    Cullen, I do like your index very much. What do you make of the recent uptick, which puts it well above the regular CPI. If the Fed were following your index, it might have already started to hike.

  • http://www.orcamgroup.com Cullen Roche

    It doesn’t surprise me. The Fed is trying to kickstart the boom/bust cycle by getting people to bid up real estate and stock prices so they feel the “wealth effect”. I think it’s misguided and poses a risk to causing distortions. I think there is probably inflation lurking beneath the surface for the first time in a long time and it’s not showing up in the best places.

  • Geoff

    Interesting, thanks.

  • Bruce in New Orleans

    Hello Geoff,
    I’ve always appreciated your posts. In my mind, housing is more like an asset that differs cost. The reason I say this is that my house has more space and costs less than my equivalent apartment. My hope is not that my house has a positive return on my investment, it’s simply to loose less money than the equivalent in rent. And if per chance some greater fool thinks that my house is worth 40% after a few years; I’ll be moving. If not, it’s still doing it’s job of not costing me a bomb.

    I bought my house for $100K and my rent was $1300 on my apartment. If my house is worth $100K after 10 years than I made out just fine as I would have paid a lot more than that in rent that I would not get back.

    My two cents anyway.

    By the way Cullen, when can I vote for you for a nationwide office?

  • Bruce in New Orleans


  • Geoff

    Thanks, Bruce. I think you’re on the right track. The rent vs own decision is not black and white, and can include many subjective factors. Where I live, renting currently makes more “cents” if I look purely at the numbers. However, I chose to own anyway, mainly because I like the control. The fact that the ladies are more impressed by a guy who owns his own home might have also entered the equation :)

  • ftm

    On the difference between consumption and investment expenditure, isn’t investment defined as not consumption? So for instance if the value of something is exhausted in the current period that’s consumption, all goods that provide or contribute to consumption in the future are investment. So why aren’t consumer durables just like housing? The value exhausted in the current period is consumption whatever remains is investment and on and on until the asset value is fully exhausted.

    And to go a little further with this, if you store non-perishable consumption goods you are investing – As those goods will provide future consumption. So consumption/investment isn’t defined by some inherent characteristic of goods but rather by whether their value is exhausted in the current period. I know this isn’t how things are generally accounted for but it seems to make sense no?

  • Richard Rosso

    Cullen hits housing, in the gut, again. With accuracy. Perhaps if housing appreciation was included in CPI we would have faced the bubble that was forming in housing. Not sure. Hindsight bias is a b****. My thought is we would have gone over a cliff, regardless. Only because housing is so embedded in the story of the American dream. Cullen – what about rents today and effects on inflation? Rents are rising dramatically in many areas. Appreciate your writings.

  • http://oneconomist.com Hans

    Excellent piece of work, Mr Cullen..Your arguments are very, very sound indeed…If Labor thinks housing is an investment or an asset, why not a motor vehicle or even the clothes on ones back.

    Strange, how Labor economists suddenly saw a need to revamp their housing model..I am of the opinion that this was done for political purposes, in reducing government cost and spending, since so much is tie to the CPI.

    If one where to compare rental and housing cost over the past 50 years, the latter would greatly outpace the former.

  • Luke

    I think you pretty much nailed it. The house is a diversion. The land is where the value appreciates. Rising land prices aren’t a whole lot different than rising oil prices, are they? They are both just rising input costs that reduce real spending power.

    In the Wealth of Nations, Adam Smith suggested that taxes on land were the best way to raise government revenue because landowners derive income through no effort of their own. Note that he didn’t advocate taxing buildings, which would be a tax on capital, which would deter productive investment. Land taxes don’t deter land building because land already exists. But land taxes do deter owning more land than you need, which would ultimately lower land values, just as subsidies like the mortgage interest tax deduction ultimately increase land values. Many libertarians may scoff at this, but let me remind you that a land title is a government-created privilege. Markets don’t create land titles.

  • Very Serious Sam

    Once again, a very good piece, thanls Cullen. As for

    “This is because a home is an asset, and an increase in its value does not impose a “cost” on the homeowner”

    An increase in house prices means also an increase in financing costs and consequently an increase in rents for tenants. Are the rentes not included in the CPI calculation?

    BTW, I myself never bought a house. But my partner owns already two, one more of many reasons for me to feel lucky I met her :)

  • GLG34

    I wonder what the real return on the average house is when you calculate all the taxes, all the upkeep and subtract that from the return we usually see. My guess is it’s not very high at all, but most people think housing is a great “investment”.

  • Brick

    I think buying a house is about shifting cash flow from retirement years to working years. The BLS gives a definition as follows in regards to owners equivalent rent.

    Spending to purchase and improve houses and other housing units is investment and not consumption.Shelter, the service the housing units provide, is the relevant consumption item for the CPI.

    What I think is being argued here is not which parts are consumption and investment but that the Shelter component has become detached from house prices. This may be due to differences in the rental and buying markets , but also due to some housing market rental segments being very small. It also does not take into account the differences in debt costs between a large institution and an individual. Delving into the definitions you can see some potentially even worse distortions though. Some out of context extracts –

    Because rents change rather infrequently, the CPI program collects rent data from each sampled unit every six months.
    For segments that contain largely owner-occupied housing units, rental units from segments close to the selected segment to help represent the segment.
    To account for this aging, an age-bias factor is applied to the current rent.
    The pricing areas are metropolitan areas and smaller urban places.

    While I think they use some very dubious fudges the key problem for me is that mortgage interest paid should be considered as part of the Shelter component even if the purchase price is not.


  • Ville

    Excellent point and so true.

  • http://www.nowandfutures.com bart
  • Jim

    “…unless one catches a rapid appreciation cycle.”

    Which is all your sister’s step-daughter needs, trying to be a market timer as a single mom of two, new to a (reasonably) steady full-time time job. And even then, catching a rapid appreciation cycle is pretty much useless unless she wants to flip the place, pack the kids up and try to catch the next “investment opportunity,” essentially become of day trader in the real estate biz where she can use her nursing training for her own nosebleeds. (I’ve been married to a nurse for 33 years — not generally their idea of fun).

    She may, and I hope she does, do just fine. But I think it reflects a general psychology that housing prices can continue to defy gravity in perpetuity. When the BLS legitimizes that psychology with dumb ass positions such as the one Cullen points out — that housing is not consumption but rather investment because house prices “frequently” appreciate — then I believe it’s a disservice and dam poor policy.

    It’s now clear how quickly housing can shift to a force for negative consumption and indeed become the predominant factor in a severe balance sheet recession. It may be boring, but I do believe muddle-through economic activity will help gradually promote housing as a roof over one’s head, nothing more. And that’s good.

  • http://None Midas II

    Henry George wanted all taxing based on land value. I recall a town in NJ that used his way and did well. He did write a book about it, I don’t remember the title. As to a house as consumption; I found the pleasure of more space, a garage, privacy, and a garden, added value to my enjoying life well beyond what a rental offered. Pleasure in your lifestyle is one of the richest things money can ‘buy’.

  • http://None Midas II

    Also,Re land value, add the famous Real Estate dogma, “Location, Location. Location.”

  • perpetual neophyte

    Thornburg asset management has done some research on this in their “Real, real, real returns” pieces and find that real estate typically just keeps up with inflation or very barely outpaces it when you account for taxes and transaction costs. I don’t think they include maintenance and repairs, but I don’t recall.

  • http://www.orcamgroup.com Cullen Roche

    Yeah, that’s a good one. Here it is. http://www.thornburginvestments.com/literature/generic_lit/TH1401_realreal.pdf

    I am also running through the data tonight with transaction costs. Buying a house is a crappy “investment”, but probably a good decision to live somewhere when compared to the sunk cost of renting. More to come tomorrow.

  • dis737

    RE is perceived to be a great investment primarily due to the leveraged returns. People are willing to take on enormous leverage on a home that they would never dream to take on with any other type of investment. In addition, the risks are lopsided favoring the home owner given that most loans are non-recourse. The RE bubble was more a function of this increased leverage effect vs. any real appreciation. I’m not sure if the CPI is really the right place to reflect this effect, but it clearly should have been picked up and addressed by the Fed at the time with all of the tools at their disposal.

  • http://highgreely.com John Daschbach

    Housing is a complicated financial asset to quantify. Houses are depreciating assets but land is a probably the most clearly defined finite commodity we have. Near many cities land area scales quadratically with linear distance from the city center, but along coasts it’s closer to a one dimensional problem (take the peninsula in SF Bay area as an example). As population increases land becomes more valuable in some proportion to the local population increase (which is mostly driven by local economic factors). I don’t see and easy way to account for this in a broad statistical measure, although normalization by some aggregate measure of rental prices might work (as these have a far more rapid response to local economic conditions).

  • Tom Brown

    Well… it is possible to purchase a house to rent out and make money on. I’m looking at one house in particular that zillow says should generate $1625/mo rent (close), but only costs $461/mo for the mortgage. I’m looking at it and crying because that’s not MY mortgage payment on it… :(

  • Not an Economist

    Indeed, a residential property that generates a positive cash flow after ALL expenses (tax, insurance, maintenance, vacancies,management fees, mortgage, etc.)can be a very nice investment AND asset…and unlike unicorns, Santa and the Easter Bunny, these types of property do exist…

  • Tom Brown

    Yeah, if I were in a position to invest NOW, seeing differentials between rent and mortgage payments like that might make me very interested.

  • Not an Economist

    In my neck of the woods the ship has already sailed and “NOW” feels too late – property prices have risen so fast the last 12 months I am concerned we are getting “bubbly” again…so of course I bought a new primary residence and am renting out my former primary residence…I will have excellent first hand experience proving the validity of CR’s recent post on REAL Real Returns and how RE is a poor investment… :)

  • Conscience of a Conservative

    Fed actions are seen as frequently causing asset bubbles, and interestingly enough the Fed takes actions to exclude so called asset prices from impacting official price levels. Fact is when home prices go up, stocks go up etc it means our dollars are losing purchase power. Too many dollars can either result in groceries going up or stocks and homes going up. The Fed distinguishes, I do not.

  • Steve W

    I agree with all your points, especially your last one about “housing as a roof over one’s head, nothing more.”

    I have a couple of (perhaps anectdotal) concerns recently, one more troubling than the other. First, I’ve heard and read about private equity firms (like Blackstone) buying up large numbers of single family homes for investment as rental units. I think most have been bank forclosures (but I’m not sure). I also read that Ron Carson (of Carson Wealth Management, a successful independent advisory firm), just put together an investment pool of rental houses for qualified clients. I didn’t read the offering documents, so I can only guess about the structure of the deal. The thing I was struck by was his confident projection of 12% returns. I only have one rental house, so I’m no expert at property management. Still, the logistics of managing dozens (if not hundreds) of single family detached rental houses, spread out all over various neighborhoods, seems like a bad idea. My other anectdote involves a client who is pretty wealthy, so he didn’t risk much when he bought a condo unit a few years ago. He admitted that he coulnd’t help himself, the unit was in the same condo complex where he lives (in the winter, in Florida). The price was just too attractive. The short version is that after spending some money on necessary updates and repairs, he sold the unit recently at what amounted to a loss (albeit a very small loss). He learne that just because the price is low doesn’t mean it won’t stay low for a long while.

    I think there’s much less speculation going on, but the private equity deals just don’t make sense. Too many lawns not getting mowed, too many locations for property managers to check on, too many different streets and neighborhoods (with different characteristics). Tenants are often hard on the properties they rent. Repairing vacated units in an apartment complex is different than managing repairs in vacated rental houses spread out heare and there.

    Oh well, what do I know? The folks at Blackstone are richer than me. So is Ron Carson. :)