How cities grow (or not)

Choosing a place to live is a major, often difficult, decision. The price of a home and the cost of rent can vary wildly from city to city, based on numerous complex and interrelated factors. 

However, research recently published in the Journal of Urban Economics aims to help demystify the underlying reasons behind these differences. 

“A city can grow persistently if it has the right characteristics: elastic housing supply, good transportation infrastructure, industries that need less land and have strong agglomeration effects,” says Guozhong Zhu, an associate professor with the University of Alberta’s School of Business and co-author of the research. 

In this work, Zhu and his co-author Sheridan Titman, a professor of finance at the University of Texas at Austin, developed a model that describes how a city’s characteristics impact volatility — large changes in values and rents of real estate. The dynamic model takes into account geographical constraints, zoning and other policies, among others, over time.

Conventional wisdom is that with less supply, additional demand causes prices to rise more. And with higher prices and less new supply, there is less population growth, Zhu notes.  

According to the paper, the model Zhu and his colleague developed provides a framework to help decision makers understand real estate risk using a more holistic, systems approach.  

Take for example, one growing city that has strict zoning laws, poor transportation infrastructure, geographical constraints — a relatively small area of land that can be developed due to, for example, being situated on an island. Prices there will grow more and the city population will grow less than in a different city that doesn’t have these constraints. 

One key factor the model uses is the agglomeration effect, or, the higher efficiency of business due to the concentration of economic activities within a city. For example, a city may have a growing tech sector, a sector that is considered highly agglomerative. This means businesses in the city, along with the high tech sector, will be more productive and efficient as more talents migrate to the city, and, thus, the city will continue to grow for a long time.

However, a highly agglomerative city may also be more appealing to homebuyers, potentially causing more demand for homes and increasing their values. However, this also depends on the other factors, for instance, transportation infrastructure and land supply elasticity. 

If Edmonton can attract high-tech firms which have strong agglomeration effects, it can continue to grow in population. “This is because the agglomeration effect causes growth to feed on itself — more growth causes higher efficiency, which in turn causes more growth,” Zhu says.

According to Zhu, if the City of Edmonton continues to relax some of its zoning restrictions, such as by allowing more single-family homes to be converted into duplexes, it could see stable growth.

“Edmonton is a growing city. The city has relatively mild supply constraints — abundant land supply, good transportation infrastructure and mild zoning restrictions,” he says. “Under the conventional wisdom, the city will keep growing and housing costs won’t go up quickly.”

Zhu and his colleague are currently working on a follow-up research project that looks at how the durability of residential houses affects price and supply in the housing market. 

According to Zhu, durability creates value in waiting for real estate developers, as they won’t build on a location unless they are sure about its price appreciation. The value for them is higher if they delay the development in prime locations where growth rate is potentially higher. 

“This partly explains the underutilized land or vacant land existing in many cities, sometimes in prime locations, like downtown Edmonton,” he says.