Small children, small problems. Big kids, big problems. Parents have heard this saying a hundred times and have probably used it themselves. And the saying is at least as frequently adapted for other objects of analysis, including the housing markets: small cities, small prices. Big cities, big prices. That sounds plausible. If you look at the independent cities in Germany, the highest existing apartment prices for a standard apartment are actually paid in the largest cities, especially Munich, Frankfurt, Berlin and Hamburg.[1]
And if you place a simple regression line through the point clouds (here East and West German cities separated), a (weakly significant) positive relationship can actually be determined.
But for three reasons, real estate investors must be careful not to derive from this simple regression the investment recommendation that one should only invest in the large, so-called A cities, because there is not only high liquidity there, but also high growth in value. First, of course, only a simple regression was estimated here, and univariate analyzes usually fall short. Secondly, this connection is primarily due to the few outliers with very high population numbers. Thirdly, this approach ultimately represents a look in the rear-view mirror and could only be reformulated as a recommendation if large cities were to develop greater dynamism in the long term.
In fact, it cannot even be said that housing prices in large cities grew particularly quickly in the last upswing (from 2010 to 2022); There were a number of smaller regional centers whose price growth was even higher than that of the A cities. For West German cities, there is no connection between the size of the city and the average annual performance during this period. For East German cities, the remaining positive connection is primarily due to the special role of Berlin.
But this also means that it is much more important to pay attention to the change in the number of inhabitants, and not to the sheer size, because here the positive connection is actually more pronounced, and this is also plausible: the change in house prices is caused by the change in demand determines. The size only comes into play when there are no more options for densification or expansion and when there are monocentric cities where the best locations are in a narrowly defined inner city area.
In fact, the diversity of German cities also enables diverse growth processes. Population growth in cities is often not dependent on size, but rather follows almost idiosyncratic processes: designation of building land, success of companies, infrastructural expansion, educational policy decisions, other amenities. Gibrat’s rules are at work here, according to which the size of a city does not correlate positively with the growth rate.
And yet it’s worth taking a closer look here too: at least since Glaeser et al. (2010) have shown that the validity of Gibrat’s Law for urban development processes is not eternal for US cities, it should be emphasized that there can be shocks that can lead to a significant and long-lasting deviation from it. The last diagram illustrates this for the German district towns in the east and west. Gibrat’s law can be seen perfectly in the data for West German cities. There is no size dependence in population growth, at least not in the period examined here from 2010 to 2022. For the East German districts – and this time not only due to the outlier Berlin – a positive connection can certainly be shown for this period. In fact, the connection is even stronger when Berlin is removed from the sample. There may have been many reasons for this, most of which are probably related to the adjustment processes of German unification, which in a first phase led to a sharp decline in population in all eastern German regions and in a second phase to a noticeable strengthening of the metropolitan areas. These catch-up processes in the growth centers did not take place across the board, but were concentrated in the larger cities, which, thanks to the very relaxed housing markets, were able to absorb additional residents from the surrounding regions more than western German cities.
In summary, it is probably not the simple investor rule of thumb that one would only be happy with real estate investments in the big cities, but even the much more complicated growth law according to Gibrat, at least in the generally applicable interpretation. Rules of thumb help, but not always, especially not in a world where sharp pencils have to be taken into account. After all, it remains true that larger cities offer liquidity advantages for investors – there are simply more transactions. But this advantage is likely to depress returns in a world of highly competitive capital markets.
For further reading:
Glaeser , EL , Ponzetto , GAM , Tobio , K. , (2012). Cities, Skills and Regional Change. In: Regional Studies, S. 1-37.
Just, T. Stephan, P. (2009). The strangely stable size structure of German cities. Zipf’s law and its implications for urban regions. Deutsche Bank Research. Research Notes 31. Frankfurt aM
[1] Offer prices for standard apartments based on hedonic price recordings for 106 German district towns are used here.
IREBS Real Estate Academy and University of Regensburg.