About a month ago, I posted a question on LinkedIn asking for help understanding how the Bureau of Labor Statistics could possibly be reporting an inflation rate of 5.5% for Shelter given the stagnation we are seeing in most multifamily rent growth statistics. This figure represents 37% and 15% of the Consumer Price Index and Core PCE, respectively, which the Federal Reserve relies on to set interest rate policy. My linkedIn post had 29,000 views. A quarter of the views were from people with the very senior title of CEO, President, Managing Director, Founder, etc. Most respondents were equally as baffled. I did get some feedback from some property owners that they are still getting increases from renewals, however, they admitted that they are still working through rent growth that actually occurred in 2021. Without a rational explanation, I questioned the integrity of the data that the Federal Reserve is using to set interest rate policy.
Clarity from the Boston Fed
Recently, the Boston Federal Reserve issued a paper called “A Faster Convergence of Shelter Prices and Market Rent: Implications for Inflation” which helped to explain my confusion (link to paper below). In the paper, they define a term called the “Market Shelter Gap”, which essentially tracks the difference between market rent and CPI Shelter.
CPI shelter might be expected to move closely in line with market rent. However, several studies demonstrate that CPI shelter tends to lag market rent. An important reason for this lag is that market rent reflects only the rents paid by new tenants, whereas CPI shelter captures rents paid by new and existing tenants. I refer to the difference between market rent and CPI shelter at any point in time as the “market–shelter gap.1
In effect, the asking rent might skyrocket, as it did in 2021, but the market is imperfect and it might take time for landlords to actually pass along those market rent increases to their tenants. The paper goes on to quantify the impact of the Market Shelter Gap.
If shelter prices were excluded, monthly annualized core CPI inflation rates would have ranged from 1.8 to 2.4 percent from July 2023 through February 2024, whereas the full, realized core CPI inflation rates over this period ranged from 3.8 to 4.7 percent.1
Is the sole reason we believe we are in an inflationary environment that the rent growth that occurred in 2021 is finally showing up in the data? A representative from the Federal Reserve just admitted that they would be within their target had it not been for Shelter. Is that really the best way to evaluate the current economic environment? Almost every real estate data collection service would say that rent growth nationally is hovering on average around 1% with declines in most markets.
Impact for Real Estate
The spike in interest rates has had a devastating impact on new supply of multifamily, especially in high barrier-to-entry markets. Financing costs have doubled and coupled with an overall pull back in the debt and equity financing markets, very few development projects are on track to begin construction this year. The chart below from Costar illustrates this trend, which predicts that 2026 will have the lowest levels of new supply since 2013 with strong projected absorption levels.
The national vacancy trend does not tell the full story. Currently high barrier to entry markets like New York City, San Francisco, Los Angeles, Miami and Chicago are currently experiencing vacancy rates below 6%, while low barrier-to-entry markets like Dallas, Houston, Austin, Raleigh and Nashville are over 10%. In those markets and submarkets where demand exceeds supply, we could see significant rent growth. Ironically, the interest rate policy of today could like create an inflationary environment in the 2026 timeframe. This would be good for owners of real estate, but lead to a continued inflationary environment.
Conclusion
The current interest rate policy set by the Federal Reserve defies logic and could potentially create a situation that actually creates a more an inflationary environment, given how prevalent Shelter is in the data that they review. A representative from the Boston Federal Reserve admitted that they would be within their target if their data analysis methodology did not have a multi-year lag. Keeping interest rates high will ultimately benefit owners of real estate, since it has essentially shut down the development pipeline, however, it is bad for the economy, because at this point, the lack of new supply will create significant rent increase due to a supply/demand imbalance.
References
SEE IMPORTANT RISK DISCLOSURES BELOW
This article is for informational purposes only, and is not a recommendation or offer to buy or sell securities. Information herein may include forward looking statements and is for informational purposes only. Forward-looking statements, hypothetical information, or calculations, financial estimates and targeted returns are inherently uncertain. Past performance is never indicative of future performance. None of the opinions expressed are the opinions of RealtyMogul. Advice from a securities professional is strongly advised, and we recommend that you consult with a financial advisor, attorney, accountant, and any other professional that can help you to understand and assess the risks and tax consequences associated with any real estate investment. All real estate investments are speculative and involve substantial risk and there can be no assurance that any investor will not suffer significant losses. A loss of part or all of the principal value of a real estate investment may occur. All prospective investors should not invest unless such prospective investor can readily bear the consequences of such loss.
RealtyMogul and its affiliates are not registered as a crowdfunding portal. Unless stated otherwise in writing, RealtyMogul and its affiliates do not offer brokerage or investment advisory services to the Platform’s individual users. RM Adviser, LLC, a wholly owned subsidiary of RealtyMogul, is an SEC-registered investment adviser providing investment management services exclusively to certain REITs and single purpose funds. Past performance is not indicative of future results. Forward-looking statements, hypothetical information or calculations, financial estimates, projections and targeted returns are inherently uncertain. Such information should not be used as a primary basis for an investor’s decision to invest. Investments in real estate, including those offered by sponsors using the RealtyMogul platform, are speculative and involve substantial risk. You should not invest unless you can sustain the risk of loss of capital, including the risk of total loss of capital.