Falling Star Cities

Robert Shiller says rates of return on housing in "superstar cities" do not exceed rates of return elsewhere:

Superstar cities may be investors' superstardust, by Robert J. Shiller, Project Syndicate: 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.

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...