APPENDIX 4 OWNER–OCCUPIED HOUSING (OOH)
INTRODUCTION
1. The measurement of owner-occupied housing (OOH) in a CPI poses some complex issues which are not encountered elsewhere in the CPI basket. A house is a consumer asset with a long useful life, generally purchased on credit, with active resale and rental markets in which households participate as both buyers and sellers. This is why a consumer price index for OOH may be built around the cost of using a home, the cash outlays on a home, its assumed rental value or its purchase price. For most other commodities, including consumer durable goods, a CPI is simply based on the purchase price.
CONCEPTUAL APPROACHES FOR MEASURING OWNER-OCCUPIED HOUSING
2. The main alternatives for measuring inflation faced by owner-occupiers in a CPI are the cost-of-use approach (of which the rental equivalence approach is a variant), the outlays approach, and the acquisitions approach. All these approaches to OOH are conceptually sound, have a basis in economic theory, and all have their strengths and weaknesses. The choice of approach is dependent on the primary purpose of the CPI and the suitability of data sources - whether it be for measuring household inflation, for measuring changes in living standards, or used for adjustment of incomes.
3. The cost-of-use approach aims to estimate the actual and imputed costs of using the OOH stock in any given period. This is more complicated for housing than other consumption items because it is a durable good that delivers services over many periods, well beyond the date of purchase. Typically, the costs that are measured include interest payments of mortgages, depreciation and other recurring costs such as taxes and minor maintenance costs. The opportunity costs of investing financial assets in a house and capital gains could also be included. However, these factors are often excluded based on the argument that capital gains and foregone interest earnings are regarded as investment components of the house purchase decision, and are not relevant for the consumption of housing services.
4. The distinction between time of acquisition and time of use is particularly important for OOH. Under the acquisitions approach, the price of an owner-occupied dwelling is captured at purchase. The cost-of-use approach measures the gradual and smooth process of 'using up' the dwelling owned by the household and requires that the index measures period to period changes in the prices of the flows of services provided by the dwelling. The outlays approach simply measures mortgage interest payments as the principal component of OOH.
5. Expenditures and prices for durable goods are easily recorded (e.g. the price of a car or couch), whereas estimating the prices of the flows of services provided by durables like OOH is far more difficult because it cannot be directly observed. These conceptual and practical barriers can often lead to statistical agencies adopting a hybrid approach, that is, using the acquisitions approach to capture expenditures on consumer durables while a cost-of-use method (e.g. rental equivalence) captures the services provided by residential structures owned by the occupants.
6. The outlays approach reflects actual consumption-related cash outlays on owner-occupied homes made by households over the period in which the consumer good is used. In general, this includes mortgage interest payments, property taxes and maintenance and repair costs. Imputed costs are excluded by definition, as are investment-related outlays. The weight given to OOH is also generally smaller in the outlays approach. If the CPI’s primary use is as an escalator of money incomes, then the outlays approach is appropriate for such a purpose. The outlays approach is not so useful if the CPI is used as an instrument for monetary policy because of the circular effect of interest rates.
7. The final method of measuring prices for OOH is the acquisitions approach. This approach aims to measure the expenditures made on new dwellings (net additions to the housing stock) for the purposes of owner-occupation, as well as other current expenditures, e.g. maintenance costs. This method has the advantage of measuring the prices of OOH consistently with the prices of other consumer durables, such as motor vehicles and white goods. That is, purchases of housing from other private households are excluded, and the expenditure is recorded at the time it is made rather than as the value of the flow of services being imputed over the life of the asset.
8. In practice, acquisition measures exclude the value of land (investment component) from the value of new dwellings (consumption component). One consequence of these assumptions is that the weight assigned to OOH under the acquisitions concept is relatively small compared with the cost-of-use and rental equivalence approaches.
9. The CPI Manual (ILO, 2004) devotes considerable space to discussing the theoretical strengths and weaknesses of these alternative approaches and describes the data requirements for each. In section 10.5 it states: "Ideally, the approach chosen should align with the conceptual basis that best satisfies the principal purpose of the CPI" (ILO, 2004).
SHOULD AUSTRALIA ADOPT A HYBRID APPROACH TO OOH?
10. There is considerable diversity in the way countries measure the cost of OOH in their CPIs. Due to the conceptual and methodological complexity of measuring housing costs, many countries use simplified variants of the cost-of-use approach (the most common being the rental equivalence approach). While some countries exclude OOH entirely from the CPI, most adopt a measure for housing that is consistent with the principal purpose of the CPI.
11. The 16th series CPI review identified some concerns in the wider community that in recent years the reported inflation for the OOH component of the CPI did not align well with the perceived price experience of owner-occupiers. The aim of the ABS research was to determine whether the CPI could be improved by incorporating some desirable attributes of either the cost-of-use or outlays approaches for the measurement of OOH.
12. In 2006 the ABS analysed the practical implications of using alternative treatments of OOH in the CPI (Woolford, 2006). The analysis was undertaken by constructing bilateral measures of price change for Sydney between 1998-99 and 2003-04. The analysis looked at five options which covered all three conceptual approaches.
- The acquisitions approach (ILO CPI reference aggregate #2 ) - Cost to the homeowner of purchasing the home outright, taking into consideration the costs associated with home maintenance.
1) The acquisitions approach excluding OOH components altogether.
2) The acquisitions approach including OOH components.
- The cost-of-use approach (ILO CPI reference aggregate #1) - A measure of the cost of the flow of services resulting from owning and living in a dwelling.
3) The rental equivalence approach (a simplified variant of the cost-of-use approach) which measures how much the homeowner would be willing to accept in rent for the dwelling.
4) The full cost-of-use approach (ILO CPI reference aggregate #1) which focuses on the opportunity cost of owning and using the dwelling.
- The outlays approach - A measure of change in prices that impact on the consumption-related cash outlays on owner-occupied homes.
13. The analysis showed that the CPI is indeed sensitive to the choice of the concept. Depending on the proportion of the reference population that are owner-occupiers, the alternative conceptual treatments can have a significant impact on the CPI, affecting both weights and, at least, short-term measures of price change.
Table 1 - Results of 2006 ABS analysis using alternative treatments of owner-occupied housing (OOH)
 | | | 1998-99 | 2003-04 | 2003-04 |
| | | Expenditure | Weight | Expenditure | Weight | Laspeyres(a) | Paasche(a) | Fisher(a) |
| | | $ | % | $ | % | | | |
|
| 1. Excluding owner-occupied housing | | | | | | | |
| Housing | 93.48 | 12.9 | 120.65 | 13.3 | 117.4 | 117.3 | 117.3 |
| | Utilities, repairs and maintenance | 39.83 | 5.5 | 49.57 | 5.5 | 121.4 | 121.5 | 121.4 |
| | Actual rents | 53.65 | 7.4 | 71.08 | 7.9 | 114.5 | . . | . . |
| All excluding housing | 632.95 | 87.1 | 783.50 | 86.7 | 116.5 | 112.7 | 114.6 |
| CPI total | 726.42 | 100.0 | 904.15 | 100.0 | 116.6 | 113.3 | 114.9 |
| | | | | | | | |
| 2. Acquisitions | | | | | | | |
| Housing | 164.78 | 20.7 | 210.81 | 21.2 | 121.8 | 121.5 | 121.6 |
| | Utilities, repairs and maintenance | 39.83 | 5.0 | 49.57 | 5.0 | 121.4 | 121.5 | 121.4 |
| | Actual rents | 53.65 | 6.7 | 71.08 | 7.1 | 114.5 | . . | . . |
| | House Purchase | 61.00 | 7.6 | 77.42 | 7.8 | 129.0 | . . | . . |
| | Property rates and charges | 10.30 | 1.3 | 12.74 | 1.3 | 119.2 | . . | . . |
| All excluding housing | 632.95 | 79.3 | 783.50 | 78.8 | 116.5 | 112.7 | 114.6 |
| CPI total | 797.73 | 100.0 | 994.31 | 100.0 | 117.6 | 114.4 | 116.0 |
| | | | | | | | |
| 3. Rental equivalence | | | | | | | |
| Housing | 241.91 | 27.7 | 299.18 | 27.6 | 115.6 | 115.6 | 115.6 |
| | Utilities, repairs and maintenance | 39.83 | 4.6 | 49.57 | 4.6 | 121.4 | 121.5 | 121.4 |
| | Actual rents | 53.65 | 6.1 | 71.08 | 6.6 | 114.5 | . . | . . |
| | Owner-occupier rents | 148.43 | 17.0 | 178.53 | 16.5 | 114.5 | . . | . . |
| All excluding housing | 632.95 | 72.3 | 783.50 | 72.4 | 116.5 | 112.7 | 114.6 |
| CPI total | 874.86 | 100.0 | 1 082.68 | 100.0 | 116.2 | 113.5 | 114.8 |
| | | | | | | | |
| 4. Cost-of-use | | | | | | | |
| Housing | 121.12 | 16.1 | 305.97 | 28.1 | 247.4 | 234.6 | 240.9 |
| | Utilities, repairs and maintenance | 39.83 | 5.3 | 49.57 | 4.6 | 121.4 | 121.5 | 121.4 |
| | Actual rents | 53.65 | 7.1 | 71.08 | 6.5 | 114.5 | . . | . . |
| | Owner-occupier user costs | 17.34 | 2.3 | 172.58 | 15.8 | 1 023.9 | . . | . . |
| | Property rates and charges | 10.30 | 1.4 | 12.74 | 1.2 | 119.2 | . . | . . |
| All excluding housing | 632.95 | 83.9 | 783.50 | 71.9 | 116.5 | 112.7 | 114.6 |
| CPI total | 754.07 | 100.0 | 1 089.47 | 100.0 | 137.5 | 131.9 | 134.7 |
| | | | | | | | |
| 5. Outlays | | | | | | | |
| Housing | 141.29 | 18.2 | 205.13 | 20.7 | 110.5 | 106.5 | 108.5 |
| | Utilities, repairs and maintenance | 39.83 | 5.1 | 49.57 | 5.0 | 121.4 | 121.5 | 121.4 |
| | Actual rents | 53.65 | 6.9 | 71.08 | 7.2 | 114.5 | . . | . . |
| | Mortgage interest charges | 37.51 | 4.8 | 71.74 | 7.3 | 90.8 | . . | . . |
| | Property rates and charges | 10.30 | 1.3 | 12.74 | 1.3 | 119.2 | . . | . . |
| All excluding housing | 632.95 | 81.8 | 783.50 | 79.3 | 116.5 | 112.7 | 114.6 |
| CPI total | 774.24 | 100.0 | 988.62 | 100.0 | 115.4 | 111.3 | 113.3 |
|
| . . not applicable |
| (a) Indexes (1998-99 = 100) |
| Source: Woolford, K (2006); An exploration of alternative treatments of owner-occupied housing in a CPI; Ottawa Group Meeting; London, May 2006. |
OBSERVATIONS
14. For those measures including owner-occupied housing, in 1998-99, the expenditure aggregates vary from a low of $754.07 (
cost-of-use) to $874.86 (
rental equivalence) - a 16% difference. The relative weight for housing also varies from a low of 16.1% (
cost-of-use) to a high of 27.7% (
rental equivalence).
15. A similar picture emerges in 2003-04 with the exception that the weight for housing under
cost-of-use increases to 28.1% (up from 16.1% in 1998-99).
16. The aggregate Laspeyres price indexes for all variants except
cost-of-use lie within a relatively narrow band - 115.4 for
outlays to 117.6 for
acquisitions. The
cost-of-use outcome of 137.5 (i.e. a 37.5% increase between 1998 and 2003) is clearly larger than the other approaches.
EVALUATION
Cost-of-use approach
17. The full
cost-of-use approach is the least preferred approach based on the grounds that it includes asset price inflation (capital gains) which can prove problematic for consumer price index construction (i.e. potentially having negative prices). For instance, the results in Table 1 illustrate the volatility of the weight assigned to owner-occupier
cost-of-use - growing from 2.3% to 15.8% of the CPI over five years. The weight for housing under the full
cost-of-use approach increases significantly in times of housing booms and the volatility of this weight over time would be a concern.
Rental equivalence approach
18. The
rental equivalence approach measures the rise and fall of house prices, indirectly through imputed rents. This approach would raise significant practical problems for construction of the CPI. The weight to be assigned to the Housing group would need to be adjusted to recognise that all owner-occupied households are paying 'imputed' rents to themselves. Crucially, this approach does not represent a consumer price facing households (i.e. based on a market transaction). This approach also results in a disproportionately large weight on Housing. Using this approach the weight for Housing in the CPI could jump from around 20% to close to 30%.
19. The ABS considers that one of the most important qualities in a price index is that it reflects actual movements in the period being recorded. As rents generally change infrequently (due to annual increases or when tenants change), one drawback of using the
rental equivalence approach is the possibility that the CPI becomes less reliable as a measure of contemporary movements in the price level of OOH.
20. Using rents data can often lead to delayed effects of movements in the cost of housing - that is, that current movements in the CPI often tend to reflect past movements in the price of housing and that the CPI might conceivably be moving upwards when prices were in fact static or indeed falling. The US BLS experienced such situations between 1999 and 2006 where the BLS's Owners’ equivalent rent (OER) index and Rent index diverged.
Outlays approach
21. The inclusion of interest charges within the
outlays approach would make its use unacceptable in a household inflation measurement designed principally for the use of inflation targeting. Interest charges do not represent a price of goods or services.
Acquisitions approach
22. Under the
acquisitions approach, price inflation for OOH is represented by the purchase price of new dwellings (excluding land), local government rates and charges, house repair and maintenance expenses and charges for house insurance services. In principle this extends the scope of a CPI to include household gross fixed capital formation. The treatment of OOH under the
acquisitions approach requires the separation of the consumption and investment elements of OOH - that is, land is treated as an investment item not a consumable item.
23. The problem confronting compilers of OOH on an
acquisitions basis is the difficulty separating the investment and consumption elements of OOH. Given the CPI is a price index for consumption goods and services consumed by households, it is important to only include the consumption element. The CPI Manual (ILO, 2004) suggests that the cost of the land be regarded as representing the investment element and the cost of the structure as representing the consumption element:
"The structure may deteriorate over time and hence be consumed, [however] the land remains at constant quality for all time. As the land accounts for most of the variation in observable prices for otherwise identical dwellings sold at the same point in time, the exclusion of land values may also be seen as an attempt to exclude asset price inflation from the CPI" (ILO, 2004).
24. The ABS considers that adherence to the
acquisitions approach for OOH is appropriate considering the concept the Australian CPI is attempting to measure. The
acquisitions approach is consistent in concept and practice with the overall purpose of the CPI. The method of pricing OOH (pricing project homes) is easily understood by users, and more importantly, it reflects actual price movements in the period being recorded.
25. There is international support for the use of the
acquisitions approach as the main conceptual measurement construct for OOH. The Harmonized Index of Consumer Prices, which is primarily designed for comparison of prices between European countries, looked into the relative merits of the different approaches to OOH. Conceptually the
acquisitions approach is preferred by Eurostat to construct the OOH component. As in the ABS analysis, the full
cost-of-use approach is considered the most volatile by Eurostat (Eurostat, 2010).
26. One criticism of the use of the
acquisitions approach to OOH in CPI statistics is that its construction does not necessarily adhere to the conventions used in compiling the National Accounts. The conceptual basis for the
acquisitions approach to OOH begins with the premise that OOH has a dual nature - part consumable and part asset. However, National Accounts consider an owner-occupier's house to be an investment. National Accounts separate the ownership of dwellings from the household sector - creating notional transactions between households as landlords and tenants. While this provides an effective mechanism for measuring economic activity (distinguishing the value of the flow of services actually consumed by households), the distinction is considered less relevant for a measure of price inflation.
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