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Bubble-Proof Markets

Five superstar cities outperform the rest of the nation over time, thanks to healthy economies and rising incomes

By Paul Kaihla
Business 2.0 Magazine
October 25, 2006

About the last place a prospective homebuyer might want to peruse MLS listings these days is in one of the country's most expensive markets, like San Francisco, where the median cost of a single-family dwelling has jumped 37 percent since 2003. (It's now more than triple the national figure.)

A couple of leading economists, however, think buyers shouldn't be intimidated, even if prices in these markets go into a slump. San Francisco, New York, and a small handful of other big cities may suffer dramatic swings in a downturn, but their long-term trends "are so strongly upward that if you're willing to buy and hold, it's a good strategy," says Todd Sinai, an associate professor of real estate at the Wharton School and coauthor of a recently released study called "Superstar Cities."

The same logic, Sinai says, applies in other inflated markets like Boston, Los Angeles, and Seattle.

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So what are the criteria for bubble-proof status?

Limits on the supply of new land and buildings factor heavily, but even more important are trends in household income. According to the study, prices are likely to keep climbing in cities where poor and middle-class households are being nudged out by rich ones. The phenomenon skews prices higher than the national average because more dollars are chasing fewer properties.

According to Joseph Gyourko, who coauthored the study with Sinai, living in these areas is akin to owning a scarce luxury good. "If you think of these cities as factories for high-income households," Gyourko says, "then the demand for luxury goods will continue to rise as long as you're creating rich people."

Another way to put it is that the growing wage gap between rich and poor Americans is being mirrored in real estate, and the income schism is especially exaggerated in wealthy cities with little new construction.

On the opposite end of the spectrum are places like Las Vegas, which, despite the huge run-up in prices in recent years, is adding more than 30,000 new homes a year, and where the growth in wealthy households lags behind the national average. Since the 1980s, the proportion of households in Vegas earning $110,000 or more a year barely grew; in San Francisco, it's jumped by more than 20 percent.

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The upshot? While Vegas could be looking at a price drop of as much as 13 percent, Sinai believes the Bay Area may not have one at all.

Investors who are catching on to the research aren't waiting.

Ryan Lugbauer, whose partners own dozens of buildings in San Francisco, paid $670,000 in September for a single-family Victorian in the Inner Mission, a Latino neighborhood in transition. He plans to spend as much as $250,000 to turn the house into a duplex.

"It's a great time because there are fewer bidders," Lugbauer says. "Politicians here restrict development to a minimum, and it ends up driving up prices because the big earners want to live here. That's never going to change." Lugbauer thinks he could put his fixer-uppers back on the market for a combined $1.4 million as early as next year.

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