During the current recession, suburban home prices have tended to fall by larger percentages than (some) central-city home prices. People have offered lots of explanations. Suburbs have lost their luster because of changing tastes. Suburbs' higher transportation costs have finally caught up with their homeowners. Suburbanites, perhaps, are less secure financially than city dwellers, or are more likely to have to stretch to buy a home. Some or all of these could be true.
But everyone seems to assume that a steeper decline in the price of a home necessarily implies a steeper decline in the demand for the place. It does not. Even if demand for each place in a city drops by the same percentage, suburban home prices must drop by a larger percentage than central-city home prices, assuming transportation costs do not also decline. More precisely, home prices must drop by a larger percentage in places with higher relative transportation costs.
People confuse demand for a home in a given place and demand for the place itself. In a recession, what actually declines is demand for the place. Residents are poorer, the city offers fewer jobs and amenities, and city services decline. Residents, on average, are not willing to pay as much to live in the city -- or any given place within the city.
The cost of living in a place is not just the cost of housing. The cost includes transportation. This cost varies by place. Suburban home owners pay less for homes and more for cars, while residents of swank central-city neighborhoods, close to jobs and city amenities, pay lots for housing and relatively little for transportation (especially after considering the time cost of commuting).
This is a trite observation, I know. But it matters. It means that when demand drops for a place, the drop in demand must be reflected in either lower housing costs, lower transportation costs, or both. When demand for a place drops but transportation costs do not, then the cost of housing must absorb all of the decline. Which means housing costs must drop by a larger percentage in places where housing costs are a smaller part of the budget. This is true even if each place in the city sees the same percentage decline in demand. The demand for a house in a given place is not equivalent to the demand for the place itself.
The algebra is not hard, but it’s easier to explain with a (grossly oversimplified) example.
Let's assume that during a recession the demand for each place in a given city drops by 10%. Consider two neighborhoods:
In neighborhood 1, an expensive neighborhood near the city core, the typical household's transportation costs are negligible compared to the cost of the home itself; for all practical purposes, each household spends 100% of its "housing" budget on the home. In neighborhood 2, an inexpensive exurb far from jobs, the typical household spends only 50% of its housing budget on the home itself and spends the other 50% on transportation.
If transportation costs hold up, then housing costs must absorb all of the drop in demand.
This is a simple calculation for neighborhood 1: the price of each home drops by 10%.
Demand for each place in neighborhood 2 likewise drops by 10%. Again, housing costs must absorb all of the decline because transportation costs do not change. But if home prices in neighborhood 2 were to drop by just 10%, as in the central neighborhood, the total cost of living in neighborhood 2 would drop by just 5%. In order to get a 10% drop in the total cost, home prices must drop by 20%.
It looks to all the world as if demand for the suburban neighborhood has dropped more than demand for the central-city neighborhood, but the demand for each has dropped by the same percentage. The suburbanite has simply experienced a steeper drop in a smaller percentage of his total cost for the place.
Let’s consider three other scenarios.
Expensive suburbs. In a suburban neighborhood of $1 million mansions, the cost of housing might be a very large percentage of the total budget. Home prices in these neighorhoods will react like home prices in central-city neighborhoods.
Poor, central-city neighborhoods. Transportation is cheap in poor, central-city neighborhoods. But housing sometimes is even cheaper. Homes can be so cheap that housing makes up a relatively small percentage of the total cost of the place. Then a drop in demand would have the same effect as in the ‘burbs: home prices would drop by disproportionately large percentages. Counter-intuitively, the cheaper the housing, the larger the percentage drop in home prices. (This should sound familiar.)
Polycentric cities. Average transportation costs do not vary as much from neighborhood to neighborhood in a polycentric city. (Note this does not mean the city's average transportation costs are lower than another city's.) At the extreme -- when jobs and amenities are evenly distributed within the city -- average transportation costs are exactly the same everywhere. In such a city, all that matters is the cost of housing. The cheaper the housing, the smaller its percentage of the housing budget -- and the steeper the decline in the price of the home.
We thus don’t have to posit any change in housing preferences or demographics or the geographical distribution of subprime borrowers to explain why suburban home prices decline more steeply than (some) central-city home prices during a recession. It’s just algebra.
None of this is to suggest that other factors aren’t at play. We might very well be seeing a shift in the type of communities people prefer -- although any such shift surely began long before this recession. And in some cities, the credit-risky and financially precarious have been relegated to the suburbs; these were the first to feel the recession's pangs, and the first to default on their mortgages en masse.
But do note that these alternative explanations imply alternative predictions. If there has been a fundamental shift in preferences, then suburban home prices will remain (relatively) depressed even after the economy recovers. If this little model is right, suburban home prices will recover by a larger percentage than central-city home prices.
One could argue with my assumption that transportation costs hold steady. It's not a bad approximation in the short run. Residents (at least those who keep their jobs) must make the same commutes as before, make the same drives to the grocery store, etc. The time cost of commuting is a big part of the overall cost. But if, say, gas prices do decline -- they have in this recession –- then that decline will offset the decline in suburban housing costs somewhat.
One last point. I'm using "housing cost" interchangeably with “home value.” This is sloppy. For suburban renters in my first example, a 10% drop in demand means a 20% drop in rent, holding transportation costs constant. The suburban renter really is no better or worse off than a central-city resident who pays nothing for transportation but sees only a 10% drop in rent.
It’s the suburban landlord who takes the real hit. She loses 20% of her asset's value; it is little solace to her that her renter pays such a small percentage of her budget for housing.
Homeowners, of course, are both renters and landlords. They seem to worry only about the value of their asset — understandably, since they are highly leveraged. But the decline in the value of their asset is offset by the decline in the imputed rent they pay, which is why those who lose their homes to foreclosure often can afford to rent them back from the bank. As renters, they are no worse off than anyone else in the city; they just get burned as investors.
