When you think you understand how the CPI (Consumer Price Index) works and how to use it, you assume everyone else does as well. Our recent experience at Ruminations has taught us the folly of our living in our own world. Recently, we’ve seen several cases proving us wrong; two of them leading to litigation, and one to a client (almost) miscalculating an important investment decision, a smart client at that.
So, with apologies to those of you who already know this stuff, here we go.
The CPI is determined and published by the U.S. Bureau of Labor Statistics (BLS, for short). You can find the current CPIs and historical numbers on its website at: data.bls.gov.
Did you catch that? We wrote “CPIs,” a plural, not “CPI,” the singular. That’s because the CPI isn’t just one set of numbers. More about that later.
According to the BLS, the CPI “is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.” There are CPI numbers published for two different groups of those urban consumers: (a) all urban consumers (87% of the total U.S. population); and (b) urban wage earners. What about the other 13%, you ask – farm communities, members of military, prisoners, long-term hospital patients – they aren’t included because their market baskets are distorted by self-sufficiency and subsidies.
There are two indices for “all urban consumers,” the “normal one,” designated at the CPI-U, and a “chained” index, designated as the C-CPI-U. It is the one that keeps rearing its head as a proposed substitute for adjusting Social Security payments, mostly because it shows a lower market basket cost than does the CPI-U. It’s complicated, but what it does is change the “market basket” as some of its items rise too quickly in price. The theory is that if the cost of a particular item in the market basket gets “too” high relative to the other items, consumers will reduce their demand for that item or substitute a lower cost one. Today, though it is calculated and reported, no one we know uses it.
The index for “urban wage earners” is designated as the CPI-W. Urban wage earners are households where more than half their income comes from clerical or wage jobs and at least one wage earner has been employed for the prior 37 weeks. This group is a subset of “all urban consumers” and constitutes about 37% of “all urban consumers.”
Why is there a CPI for a 37% subset? That’s because that subset buys a different market basket mix of goods and services than does the entire urban consumer population. Which one to use? You pays your money and you takes your chances. It probably won’t make a difference although when we try to explain the relevance of using the CPI to set rents and to make similar adjustments, the sociological differences in spending patterns between those who live on investment income and those who get a year-end Form W-2 might have some (ignorable) economic significance.
Before we run away, in all fairness, there are other indices available to measure economic changes. Though very rarely used in leases and also rarely used in other agreements, they may have some special utility for unique agreements. One example is the Producer Price Index which measures the cost to manufacture items. Another is GDP Deflator, an inflation index that looks at consumption by governments and institutions in addition to the consumption of “ordinary” consumers.
At a minimum, readers should now realize that you can’t just write that adjustments will be made by using the “consumer price index” because that won’t tell anyone which of the two or three kinds of indices we’ve described should be used. But, it gets worse than that. There are almost 400 different CPI-U and CPI-W indices. Beyond the “U.S. City Average,” a national index, indices are published for regions, urban areas, metropolitan areas, and non-metropolitan areas.
Fortunately, unless you have some special affinity for Pittsburgh and insist on using its semi-annual (six month average) index, you’ll be looking at only four candidates in two flavors each (CPI-U and CPI-W). Currently, only the “U.S. City Average,” the “New York-Northern NJ-Long Island, NY-NJ-CT-PA,” the “Chicago-Gary-Kenosha, IL-IN-WI,” and the “Los Angeles-Riverside-Orange County, CA” indices are published monthly. The hundreds of others are published less frequently. For this reason, most people who know what is going on stick to one the two flavors of one of these four monthly indices.
Hang on, its gets more complicated. These indices are published with their monthly numbers and are also published with annual average indices (the average for an entire calendar year). The issue is one of “volatility.” Comparing a particular September’s index with the one for the previous September can be distorted by a spike in the later year or in the earlier year, one that would eventually even out. However, using the (average) index for one year and comparing it to an earlier year, kind of, sort of, evens the “spikes” out. Does it make a big difference over a long period of time? Probably not enough to worry about it when it comes to rent, but it might make a difference if you are working with billions of dollars. Whatever be the case, you’ve been forewarned.
Before we venture out into the mathematics of using a CPI to adjust “money things” from year to year, we’ll stick our neck out and tell you “why” the CPI has any relevance. We’ll do that because a fair question would be: “What does the CPI have to do with rent increases? Isn’t the CPI a way to measure the change in the price of a loaf of bread from month to month?” That’s the point. Money is an exchange medium. It isn’t useful other than to compare the value of something you want (to buy) to something you want (to sell). Let’s try that a different way. One thing a landlord does with the rent money is to buy bread. It wants to buy as much bread in 2013 as the rent money allowed it to buy in 2000.
We’ll do this another way. What a landlord really wants for the 2000 rent is to be able to buy a market basket of goods and services. It is hard for a tenant to assemble such a market basket, so the parties agree that money (rent) will do. How much rent in 2000? Answer – enough to buy that market basket. Now, for 2013, the landlord still expects buy a market basket of goods and services, but the cost has gone up. So, the tenant, still not wanting to assemble “that” market basket in 2013, stands ready to pay over cash instead. But, how much does it need to pay for the cost of a 2013 market basket? Answer – just look at the change in the CPI. After all, it tracks the change in the cost of a market basket of goods and services from period to period.
Keep that “loaf of bread” explanation in the back of your head because we’ll be concluding today’s posting with what some readers will think is a pretty radical thought, and it will be based on buying loaves of bread.
Almost all of the indices are based on the average cost of that theoretical “market basket of goods and services” for the three year period of 1982 through 1984. That’s why you’ll see “(1982-84=100)” when you see the full name of a particular index. The “100” is the starting point. If the average cost of that theoretical market basket was $400 over 1982 through 1984, $400 is assigned a CPI value of “100.” [In another part of the country, that market basket might have cost $435, but its corresponding CPI value would also be 100. We learn from this that you can’t compare the CPI for New York to the CPI for Los Angeles and know which city has the more expensive market basket unless you knew the market basket’s average cost over the 1982-84 period.]
DANGER: MATH AHEAD. If you feel math challenged, you’re probably wrong. But, even if you have that common fear, plow ahead. You don’t need to follow the math. Just assume we’ve done the multiplication and division correctly. Accept the calculations and pay attention to the conceptual conclusion the math supports.
Now, here’s what happens. If you see that the CPI for a given month is 150, then you know that market basket costs 1-1/2 times that month than its average cost over the 1982-84 period (that’s 150 divided by 100, which is 1.5 or 1-1/2). If the index goes up to 175 a few years later, the market basket now costs 1-3/4 times what it cost in the 1982-84 period (because 175 divided by 100 is 1.75 which is the same as 1-3/4). But how much more did the market basket cost in the 175 CPI month compared to the 150 CPI month? Answer – 16.67% more. Why? Because 175 divided by 150 is 1.16667. Yes, if you multiply the market basket cost for the earlier period times 1.16667, you get the cost of that market basket for the later period.
“Tell me that again, but use rent as an example.” OK, but first we’ll show you one form of a properly written CPI rent adjustment provision:
The Fixed Rent for each calendar year will be the Fixed Rent for the immediately prior calendar year multiplied by a fraction, the numerator of which is the CPI (as defined below) for the November immediately preceding the later calendar year and whose denominator is the CPI for the November immediately preceding the earlier calendar year.
For purposes of this Lease, “CPI” means the Consumer Price Index (All Urban Consumers, New York-Northern New Jersey-Long Island, NY-NJ-CT-PA, 1982-84=100) issued by the Bureau of Labor Statistics of the United States Department of Labor. If the Bureau of Labor Statistics ceases publication of this Consumer Price Index, then Landlord, using reasonable judgment, will select another index similar to the one previously published Bureau of Labor Statistics.
OK, let’s try that for 2013. Suppose the Fixed Rent in 2012 was $100,000 a year. Suppose the CPI we chose was 254.285 for November, 2012, the November before 2013 started (it actually was 254.285!). Further suppose the CPI for November, 2011 (the November before 2012 began) was 249.317 (it was!). So, we divide 254.285 by 249.317 and get 1.0199 (that’s about a 2% increase). Now, multiply this by the 2012 rent of $100,000, and you get the 2013 rent, or $101,990.
There a few things “hidden” inside the sample provision. First, and very importantly, the year chosen for the CPI corresponds to the rent “year.” We’ll explain that not very far below. Second, we picked November for calculating rent that starts in January. That’s because the November index is published in about the third week of December. December’s CPI will not be known in time, and those for January won’t be known until beyond mid-February if you use the December CPI.
What’s this about matching the time period of the CPI to the base year or the year for which you want to figure out the rent, as the case may be? That’s the beauty of an index. If you didn’t realize how the CPI reflects something called a “numerical series,” and probably never heard of a “numerical series,” then no explanation Ruminations can put down on paper will make sense to you. So, in our inimitable way, we’ll try to demonstrate the point by use of an example.
We’ll start with a $100,000 a year for calendar year 2010 and a CPI rent adjustment provision like the one above. What should the rent be for 2013?
If you find the CPI table for “All Urban Consumers, New York-Northern New Jersey-Long Island, NY-NJ-CT-PA, (1982-84=100),” you’ll see that following indices for November of each listed year: 2009 = 231.708; 2010 = 235.094; 2011 = 242.652; and 2012 = 247.097.
So, to get the rent for 2011, we’ll multiply $100,000 times 235.094 (November, 2010) divided by 231.708 (November, 2009), and get $101,461.32.
Now, to get the rent for 2012, we’ll multiply $101,461.32 times 242.652 (November, 2011) divided by 235.094 (November, 2010), and get $104,723.19.
And, to get the rent for 2013, we’ll multiply $104,723.19 times 247.097 (November, 2012) divided by 242.652 (November, 2011), and get $106,641.55.
THAT’S NOT THE ONLY WAY TO GET THERE. Here is the magic of an index. An index is a numerical series. As such, it has a property now to be demonstrated. We’ll take the $100,000 and use only the 2009 CPI and the 2012 CPI to get the rent for 2013. Yes, we’ll divide 247.097 by 231.708 and see what happens. What happens is 1.0664155. And, when you multiply it by $100,000, you get $106,641.55.
WOW, the same number.
So, we could also have written our rent adjustment provision as follows:
The Fixed Rent for each calendar year will be the Fixed Rent for the first calendar year in the Lease Term multiplied by a fraction, the numerator of which is the CPI (as defined below) for the November immediately preceding the later calendar year and whose denominator is the CPI for the November immediately first calendar year in the Lease Term.
In a lot of cases, we can actually include the actual CPI for the denominator or state that it will be the CPI for November (or whatever month you choose) of “name your year.”
It doesn’t make a difference.
What you don’t want to do is to multiply last year’s rent times a fraction that uses the prior year’s CPI and the CPI from the year before the Lease Term began. In our example, that would be multiplying the 2012 rent of $104,723.19 by the 1.0664155 we got in our second example above (the one-step calculation). If we do that multiplication, we get: $111,678.43. That’s just wrong. But, we’ve seen leases written that way. It’s hard to believe that’s an intended result. If you think it’s no big deal because the rent we just calculated is only off by a little less than 5%, try this calculation method after 10 years and you’ll something about “exponential” growth.
The math lesson is over. And, we haven’t forgotten an earlier promise.
Ruminations isn’t all that worked up over which index to choose. We don’t think it makes that much of a difference. Perhaps it is worth a landlord’s or a tenant’s efforts to study all of the logical consumer price indices to choose the one seeming most advantageous to its interests. Perhaps we’ll do that ourselves, but not for a blog.
Another thing – it isn’t always to the “correct” thing to periodically adjust rents using the CPI or any other adjustment factor, even a “fixed annual increase.” It all has to do with the “market.” Regardless of what anyone would like to think, it is the market that sets the rent. There are always exceptions, often based on unequal market knowledge (call that “ignorance,” usually that of the tenant) or “special circumstances,” a list of which could be very long. But, at the end of the day, the rent police officer is the marketplace. Why do we drag out that old thought of ours? That’s because when you ask around and learn what the market is “asking” in the way of rent for comparable space, you need to know whether annual adjustments (or other periodic) adjustments are “already” in the rent. Simply put, when you learn that the market is asking $20 per square foot for a five year lease, is that the “first year’s rent” with expected annual increases on top of it, or has the “market” already factored in those annual increases? Those who know what this is called would tell you that, if the increases are already factored in, the $20 figure, paid monthly over the five years, will amount to the “future value” of what the market says a tenant should pay for the right of possession for the entire five years. Even if that just plain doesn’t make any sense to you, remember that when you are told that space in the neighborhood costs $20 per square foot for a five year lease, you’ll want to know if the same neighborhood treats that as a fixed rent for the entire five years, or if the $20 figure is only the first year’s rent with annual adjustments expected. Don’t tip the restaurant server if the tip is already on the bill.
Also, although using the CPI to “keep everything even” might make academic good sense, there is a benefit to “certainty.” Whether a tenant pays more or a landlord receives less, there is something to say for knowing, in advance, what the space is going to cost or what the space will yield in the way of rent.
But, that’s not our controversial statement for today. Ours, for today, is based on the “I should be able to buy as many loaves of bread with your rent in 2012 as I could have bought in 2000. That’s why we’re going to “adjust the rent by the changes in the CPI.” And, that kind of makes sense to Ruminations. BUT, part of the rent, say 75%, is going to mortgage payments (and those don’t go up just because money is getting cheaper as time passes by). This means the landlord only gets to keep and spend the other 25% for loaves of bread. So, rent adjustments should be made using 25% of the change (inevitably, increase) in the CPI, not the entire change. And, if a landlord wants a little “vigorish” or “juice,” make it a rent increase based on half the change in the CPI. If theory “made deals work,” that’s the adjustment formula we’d be seeing. But, theory doesn’t seem to have much of a place in rent negotiations and that’s why you don’t often see anything less than a full CPI jump. Now, when you do come across a document that employs only a fraction of the CPI as an “adjuster,” you’ll know why that happened and why that made “economic” sense.
Here is a bonus thought. If the deal is for rent plus payment of increases in operating expenses and taxes above a base amount, you shouldn’t be doing CPI adjustments on top of that portion of rent attributable to those base amounts. There is no valid rational for raising that part of the rent when it reflects a passed through expense and the landlord is already insulated from the effect of increases.