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May 28, 2007

Richard Florida

"Falling Star Cities"

« Ouch! | Main | Creative Britain »

Robert Shiller of Irrational Exuberance fame takes on "super-star cities."

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. ... Many people view the superstar city theory as confirming their hunch that, despite the current slowdown in home prices elsewhere ..., 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 to draw such a conclusion.

(pointer via Mark Thoma). Shiller is a smart-guy, but I line up squarely with Gyourko and company.  Surely, a huge segment of the housing market is in for a blood-bath, but the advent of the spiky world ensures that super-star markets globally will outpace the rest. BTW, Gyourko et al say clearly the super-star cities are not immune from sharp ups and down. But that in the long-run their rate of appreciation far outpaces everywhere else.

Why should home values in glamour cities increase forever? 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. ...

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. ...

Private developers ... 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 Gyourko, Mayer, and Sinai identify as superstars generally appreciated by no more than one or two percent 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. ...

Finally, as Gyourko, Mayer, and Sinai themselves note, even these small long-term differences in home price 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...


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Michael Wells

Maybe the problem is the name "Superstar Cities", which implies Michael Jordan or Bill Gates like dominance. In fact as Shiller states, these cities have only out-performed the national average by 1 or 2% a year. Hardly spectacular. Some thoughts:
• "Past performance is no indication of future returns", as the mutual fund small print says. Nevertheless, most of these cities have outperformed the average since the 1940's, so it's not a short term "bubble". Shiller's guess that it's because of size and quality of homes doesn't match my observations. In fact, most of the housing in these older cities is existing homes.
• Investing in real estate for long term gain -- you're almost always better off in the stock market, otherwise you'd see Warren Buffet flipping condos. I think Shiller has his main point here, if people see the Gyoruko study as a hot tip for big profits they're misinterpreting it.
• I think these cities will continue to lead the housing markets because their fundamentals are strong -- i.e. they're good places to live, which is the reason to move somewhere and buy a house. Portland is on the list, and while it might currently be considered a "glamour city", that certainly wasn't true until 5-10 years ago -- before that it was a backwater in many ways, but nevertheless gaining that extra 1 -2% a year for six decades.


In geographically constrained cities, higher housing prices are because of higher land prices. They are not making any more land in most superstar cities so it is valuable.

I agree with Wells comment (and disagree with Schiller) that larger homes are not responsible for higher housing prices in these cities. Most superstar cities were built out decades ago -- the homes are smaller. Moreover, many bigger, older homes have often been converted into strata duplexes or townhomes -- or torn down and replaced with duplexes or condos.

I wonder if a phenomenon of the so-called superstar cities might in fact be "falling home size" or declining square feet per person in homes. This would be in contrast to the broader North American phenomenon observed by Florida in his post a few months back about bigger houses and smaller families.

Michael Wells

I've been thinking about this and have a couple more comments. First, I think the 1-2% outperforming the average I quoted from Shiller is misleading. On looking at the Superstar study again, the average growth of all cities is around 1.5 to 2%. So outperforming the average by 2% is doubling it. That may indeed be spectacular.

But my main thought is that America is changing. Many more cities are getting arts districts, open gay neighborhoods and immigrant populations as well as amenities that were once only in college towns or big cities. America, or at least urban America, is becoming more tolerant. (The gay bar raid in Greenwich Village that started the Stonewall Riots in 1969 wouldn't be tolerated today in Omaha. Immigrant and minority families are settling in the suburbs with little resistance.)

So the number of places creative class people would consider living is probably increasing. I'm wondering if more cities are gaining in Tolerance and probably Talent, leaving only Technology before their Creative Class economies start to grow. Does this match any data?

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