Why Are House Prices So Different in Different Cities?

November 23, 2010

Let’s look at two US cities with similar median income – Buffalo, in New York State, and Los Angeles, California. Both stand around the same level at $63,000 yet the unemployment in Buffalo stands at around 7.7%. It is a full 2% below the national average, while in Los Angeles it has shot up to 11.6%. So why does the average house in Los Angeles cost $321,000, more than 3 times that of Buffalo, at $112,000?

There are a number of reasons for this, but primarily these differences illustrate the fact that the real estate market is an imperfect market – it is relatively illiquid, and slow to respond to market changes. When a boom comes, it not only lifts the prices of the homes where the new jobs are being created but it also puts an upward pressure on the less attractive areas causing gentrification and pricing out low income groups. From a real estate investors point of view there are three potential long term outcomes from this worth noticing.

Firstly, even though a city like Los Angeles has grown enormously (Buffalo was larger 100 years ago), the poorer people still earn the same in both cities. Despite needing a place to live they can still only afford the same maximum rent i.e. the average Wal-Mart worker earns the same in LA as he does in Buffalo so there is a limited budget. They simply end up commuting a longer way in LA as they are priced out of more central and well located areas. This upper ceiling in working class rents is why the rental yields in Buffalo are more than double that in LA, offering a much more attractive cash flow.

Secondly, what happens after the boom has ended? In LA this has certainly happened – the unemployment is 50% higher than in Buffalo. It has the highest number of foreclosures in the US of any major city. However, house prices remain stubbornly high. Here is where the market imperfections come in. Despite having an awful economic position, it will take years, even decades for house prices to truly reflect that (ask any Japanese homeowner). On the other hand, the Buffalo economy, being
depressed during the 70’s and 80’s, has avoided the boom years and so the prices are likely to take years to reflect the fact that the city has largely escaped the current recession.

This brings us on to the third point arising from this scenario – if housing affordability is much better in one area than another, then logic would suggest that the better value area will attract and continue to attract more people and jobs. While there is unlikely to be a large influx of Los Angeles business start-ups moving to Buffalo, they have and will continue to move to cheaper locations, perhaps elsewhere on the west coast. Just as New Yorkers begin to realise they can sell their house there and buy the same for a quarter of the price upstate in Syracuse or Buffalo, leaving plenty of cash to grow their new business start-up there. In other words, the logic dictates that affordability attracts investment.

These price differentials is a good reason for valuing property on a cash flow and yield basis and is a crucial part of the investment process. If a yield is much higher than a corresponding area in a different city, then it’s worth looking closer. Often there is a reason for this. in Detroit for example, unemployment has soared to 14% and the population is shrinking. Sure, it is affordable, but there will be upward pressure on city taxes as the city loses its tax base and downward pressure on rents as people leave the city. This can end up as a vicious spiral leading to some quite unconventional solutions being touted (like demolition of entire ‘ghetto’ areas to improve housing demand in other areas), which is happening right now). In short – investors would be wise to look for areas that combine attractive yields and affordability with economic stability and growth.

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