May 19, 2007

Be wary of property boom in 'superstar cities'

By Robert J. Shiller

IN A much-talked-about recent paper entitled Superstar Cities, economists Joseph Gyourko, Christopher Mayer and Todd Sinai argue that such high-status cities - not only London, Paris, and New York, but also cities like Philadelphia and San Diego - may show an 'ever-widening gap in housing values' when compared with other cities. The authors seem to be saying, in effect, that a housing boom in these areas can go on forever.

Any claim like that will inevitably attract attention. As a well-known sceptic about booming housing prices, I have been asked on several recent occasions to participate in debates with one or another of the authors.

Many people view the superstar city theory as confirming their hunch that, despite the current slowdown in home prices elsewhere (particularly in the United States), investors can expect to make huge long-term gains by buying homes in these cities, even though the homes there are already expensive. But, as I have said in my debates with the authors, if one reads their paper carefully and thinks about the issues, one would see that there is no reason at all to draw such a conclusion.

Why should home values in glamour cities increase forever? Messrs Gyourko, Mayer and Sinai justify their claim by arguing that these cities really are unique. They have only limited land, and if one assumes ever-increasing GDP and rising income inequality, there will always be more and more wealthy people to bid up prices in these scarce areas.

They show convincing evidence for these basic facts. Rich people increasingly populate the most expensive cities. Real GDP has been increasing at around 3 per cent a year in advanced countries, and even faster recently in many emerging countries. And, of course, we aren't getting any more land in these cities.

But what do these arguments really mean for the outlook for investments in homes in superstar cities?

Let us consider the fixity of land. While there is only so much land in any one of the existing superstar cities, in every case there are vast amounts of land where a new city could be started. And new cities are started, taking away from the 'uniqueness' of existing cities.

The best-known examples of such grand new cities are planned capitals, typically built near countries' geographic centre. These include Brasilia (1950s), Canberra (1910s), Islamabad (1960s), New Delhi (1910s), and Washington DC (1790s).

In each of these cases, a planner built the whole city infrastructure to make it a cohesive, attractive place. The obvious success of these cities, as both government and economic centres, attests to the fact that urban land derives value from the presence of a well-planned city there. Where land today is cheap, it will have great value in the future if only someone takes the dramatic step of planning and creating a whole city there.

True, the establishment of such cities is a relatively rare event. Private developers have trouble getting a large plot free of restrictions. But they tend to be ingenious at developing glamorous new areas from little towns within an hour's commute from major cities. It happens in so many places and so regularly that we take it for granted and rarely even notice it.

Indeed, since the industrial revolution, the development of such new urban areas is a central theme in the history of the world. New cities are constantly ripening like so many cherries on a tree, drawing people away from older, original cities. And the new cities have a way of looking brighter and fresher than the old urban areas, which are often seen as jumbled and decaying.

How much might we expect a home in a famous city to outperform other real estate as a long-term investment? The answer: not much at all.

Prices in the cities that Messrs Gyourko, Mayer and Sinai identify as superstars generally appreciated by no more than 1 or 2 per cent a year more than in the average city from 1950 to 2000, and even that difference is probably largely due to an increase in the size and quality of homes.

According to the Coldwell Banker Home Price Comparison Index, which compares the price of a standard 2,200- square-foot four-bedroom house across cities, the most expensive city in the US is Beverly Hills (the legendary home of movie stars). The standard home there is 4.25 times as expensive as one in an average city in the US. Assuming that quadrupling of relative value occurred over a hundred years, the excess return on investment amounts to only 1.5 per cent per year - hardly the kind of performance that real estate enthusiasts are expecting.

Finally, as Messrs Gyourko, Mayer and Sinai themselves note, even these small long-term differences in home prices across cities have tended to be offset by lower rent-price ratios in the superstar cities. For an investor, the rate of return is the sum of the rate of appreciation and the rent-price ratio, so the low rent-price ratio reduces the advantage of faster appreciation.

Most of the popular attention that the 'superstar cities' theory has received merely reflects the psychology of the housing boom that we have been seeing, as well as a wishful thinking bias. People want to believe that the boom will continue, and that their investments in their favourite city are thus special and exciting. But there is no generally applicable reason to make aggressive investments in superstar cities. On the contrary, there are many reasons to worry about investing in such places.

Robert J. Shiller is Professor of Economics at Yale University, chief economist at MacroMarkets LLC, which he co-founded (see and author of Irrational Exuberance And The New Financial Order: Risk In The 21st Century.

Copyright: Project Syndicate