Understanding the Consumer Price Index (CPI) in real estate is essential for landlords and real estate investors. The CPI measures how housing expenses, such as rent and utilities, influence inflation and property values. It also affects mortgage rates, making borrowing more or less expensive.
To succeed as a real estate investor, strategic investment decisions are crucial. So, how can understanding CPI trends impact strategic decision-making, risk management, and real estate investments? Can the CPI be used to determine annual rent increases for commercial and residential tenants?
This guide to CPI explains how this financial metric is connected to the real estate industry. You will learn how the CPI impacts:
- Property values
- Rental income
- Mortgage rates
What Is CPI?
The Consumer Price Index (CPI) measures the average change in prices that urban consumers pay for goods and services over time. In real estate, CPI is particularly linked to changes in rent prices across the country. This metric also tracks price changes for everyday items like clothing, food, transportation, medical care, and energy.
The Bureau of Labor Statistics (BLS) releases monthly data on changes in the cost of living. Expressed as a single figure, the CPI aggregates over 200 product and service categories, encompassing around 80,000 individual items. Each category is weighted based on the average monthly spending by consumers.
Analysts compare current CPI data with figures from 12 months prior to measure the rate of inflation.
Another term you might encounter is “core CPI.” This metric serves as a more consistent indicator of inflation by excluding food and energy costs, which tend to fluctuate. Thus, core inflation typically provides the most accurate picture of the economy’s health.
Why CPI in Real Estate Is Important
CPI in real estate investing is crucial for several reasons. First, inflation rates significantly influence the financial health of housing markets and the broader economy, affecting property values, mortgage rates, and rental rates.
Moreover, rising inflation can increase core operational costs. Higher expenses can impact profits and investment returns.
How Is CPI Calculated?
The BLS calculates CPI data based on a basket of consumer goods and services. This “basket of products” includes common items consumers regularly purchase. It compares the current average cost of market basket products with the same period 12 months ago. The result is multiplied by 100 to determine the percentage.
Here is the calculation for CPI:
CPI = ([current market basket cost] ÷ [cost of market basket in prior year]) x 100
Using CPI, it is possible to determine the current inflation rate. Here’s how:
Inflation rate = ([current CPI] ÷ [old CPI]) ÷ [old CPI] x 100
When calculating CPI data, analysts consider different segments of the population, including:
- CPI-U population: This refers to U.S. consumers who live in urban.
- CPI-W population: This refers to workers who receive half of their income from wage or clerical occupations.
Key Components of CPI
The CPI is composed of eight broad consumer spending categories, which encompass a variety of goods and services. These include groceries, transportation, gasoline, consumer appliances, rent payments, and funerals.
Here is a brief description of the key CPI components:
- Housing Costs: This includes rent paid to landlords, utilities included in the lease, and Owners’ Equivalent Rent (OER)—the average rent a homeowner would pay if renting. It also covers utility costs and hotel room rates.
- Food Costs: This component includes all food items such as groceries, dining out, snacks, meat, and non-alcoholic beverages.
- Apparel: Expenditures on clothing and footwear, including jewelry and baby clothing.
- Transportation Costs: This includes gasoline, airline fares, public transport, new vehicles, and auto insurance.
- Medical Care Costs: Divided into medical care commodities and medical care services, this includes health insurance, medical supplies, and medicinal drugs.
- Recreation: A wide category covering entertainment expenses, including new televisions, concert tickets, toys, pets, and museum admissions.
- Education and Communication: This includes telephone services, internet, college tuition fees, and postage, as well as computer software and accessories.
- Other Goods and Services: A broad category that includes personal care products, tobacco, haircuts, funeral expenses, and other personal services.
The largest component of CPI is shelter costs, accounting for about one-third of the market basket value. The BLS conducts market rent surveys on approximately 50,000 households, replacing one-sixth of the sample annually to maintain accuracy. Since rental increases are infrequent, data is collected every six months.
It’s important to note that the CPI only captures prices paid by the end consumer. Another measure of inflation is the Producer Price Index (PPI), which calculates price increases at the early stages of production.
CPI in the Context of Real Estate
The Consumer Price Index (CPI) has a direct impact on real estate investors. Increases in the CPI can lead to higher interest rates and mortgage rates. Year-over-year CPI trends provide insights into housing cost fluctuations, rental rates, and housing affordability. Therefore, property investors closely monitor CPI for inflation signals to inform their investment strategies.
Real estate investors should be aware that rising mortgage rates often indicate a robust economy, as increased demand for goods and services usually drives up prices. However, rising rates also make buying a home more expensive, affecting house prices and real estate values.
Here’s how mortgage rates can affect demand in housing markets:
- Increasing Mortgage Rates: While there may be strong demand for real estate, consumers might hesitate to take out loans due to higher interest rates, potentially increasing rental prices.
- Decreasing Mortgage Rates: Lower mortgage rates generally boost demand for property. However, if rates drop due to a weak economy, house prices may also fall.
Let’s delve into the impact of CPI on three key areas of the housing market—real estate values, rental income, and mortgages.
How CPI Impacts Real Estate Values
The CPI influences real estate values because it is a key measure of inflation. When the CPI rises, it indicates an increase in the cost of living. These price increases lead to higher construction costs, property maintenance expenses, and interest rates, which together can affect housing market supply.
Here are three ways the CPI directly affects real estate values:
- Supply and Demand: Higher construction costs and interest rates can limit new real estate development projects, reducing supply. This increased demand for existing properties can make real estate assets more valuable.
- Property Appreciation: Property values typically appreciate in line with inflation. As the annual inflation rate rises, average home prices generally increase as well.
- Hedge Against Inflation: Real estate investing is a strong hedge against inflation. Investors may expand their portfolios to protect cash flow against future inflation increases, potentially boosting demand and values in the real estate sector.
Relationship Between CPI and Rental Income
A rise in the Consumer Price Index (CPI) directly impacts rental income in several ways.
Rent increases generally keep pace with inflation, and in some rental markets, rents can rise even faster than inflation. This results in higher revenues and increased real estate values for landlords. However, the reverse can also occur.
Here are three ways CPI affects rental income:
- Demand for Rental Units: During periods of higher inflation and increased housing costs, more people choose to rent rather than buy. This higher demand allows landlords to raise average rents.
- Rent Price Increases: Many leases include clauses for annual rent increases. Landlords can adjust rent to align with the higher cost of living indicated by the CPI.
- Higher Maintenance Costs: Inflation impacts maintenance costs as well as the prices of goods and services. Consequently, landlords can justify rent increases based on the CPI to cover these additional expenses.
How CPI Affects Mortgages
The Consumer Price Index (CPI) indirectly affects mortgages, influencing whether borrowing money becomes cheaper or more expensive. While factors like credit history and credit reports play a significant role in determining mortgage rates, inflation impacts interest rates by affecting the broader economy.
Here are four ways CPI affects mortgages:
- Higher Interest Rates: High inflation rates reduce purchasing power, making everything, including mortgages, more expensive. Lenders face increased costs, which they offset by raising interest rates.
- Buyer Demand: Higher borrowing costs lead to fewer consumers taking out mortgages. Lenders typically raise interest rates to compensate for the reduced prices of mortgage-backed securities.
- Market Expectations: Anticipation of higher inflation can prompt lenders to increase mortgage rates to offset the expected loss of purchasing power over time. Additionally, banks may raise rates out of concern for borrowers’ ability to repay their loans.
- Economic Monetary Policy: To curb inflation, the Federal Reserve may raise interest rates. Higher interest rates can slow down the housing market, protecting the broader economy from runaway inflation.
Use a mortgage calculator to find the best financing deal for your next investment.
Final Thoughts
Understanding how the Consumer Price Index (CPI) impacts real estate is crucial for successful investing. Insights into CPI trends can guide strategic investment decisions, as inflation directly affects supply and demand for properties, property appreciation, rental income, and mortgage costs. By comprehending CPI dynamics, you can adapt your real estate investment strategies to changing economic conditions in a dynamic housing market.
