Gentrification

I have written about different premiums placed on housing that can lead to prices higher than the current net rents they generate would justify. The two I have discussed are the "ownership premium" that was argued to be fallacious and the "densification premium" that was argued to be reasonable. I will discuss the gentrification premium, an anticipation of increasing a property's future productivity by anticipation of an improvement in its neighbourhood's quality.

Gentrification is where a neighbourhood is generally seeing a rise in its "quality", however that is defined. From a strict point of view, gentrification is where a neighbourhood's real income rises. But it could well be a neighbourhood appears to be getting wealthier when the actual monetary wealth of its inhabitants is not, even though the "quality" of the inhabitants is indeed increasing. (Wealth can be measured in different ways!) To handle these two scenarios, and for reasons to be apparent, I will be looking at rents, not incomes, as a method of measuring gentrification.

A quick note on taxonomy. A neighbourhood that is "gentrifying" or "undergoing gentrification" is a measurement of its trend towards increased quality. A neighbourhood that is "gentrified" is a measurement of its current quality after the gentrification process. A gentrifying neighbourhood will become gentrified while a gentrified neighbourhood may or may not be gentrifying further.

Gentrifying eventually means a neighbourhood will be more desirable. This can be due to many factors including proximity to shopping, good schools, good quality building, status, etc. Gentrification can even be self-reinforcing, where a neighbourhood receives a good reputation and becomes even more desirable. Many will pay a premium of their incomes to live in a gentrified neighbourhood so rents as well as prices would tend to be higher. Incomes will tend to be higher as well as only those with higher incomes can afford the rents and prices but this is not absolutely true. It can also be that the neighbourhood contains some willing to spend more of their incomes on housing. Thus we have two dynamics: greater desirability generally means people are willing to pay more of their incomes to live there, and greater desirability attracts those with higher incomes. The ultimate arbiter of desirability comes down to rents charged -- whether someone is willing to pay more or has ample income with which to do so is not directly relevant, though it has significant implications about a neighbourhood's ability to make gentrification "stick".

The rents and prices of ungentrified and gentrified neigbourhoods should still line up so as to give an investor a decent return. The investor doesn't really care so much for whether a neighbourhood is gentrified. (He may care to some degree though. Perhaps a gentrified neighbourhood generally attracts a more responsible tenant meaning he can generally afford lower yields but that is likely a secondary concern and not the subject I am trying to address.)

If a neighbourhood is expected to gentrify in the future, prices can carry a premium beyond that suggested by current rents. Imagine a condo in a neighbourhood that is "the next thing". It is a quirky Bohemian neighbourhood and has lots of amenities and vibrant culture. There is an argument that over time the neighbourhood will start attracting more affluent residents or just "ordinary" residents willing to pay a premium to live there. But not yet. There are still warts around drug dealing and crime but the general consensus, vis a vis other neighbourhoods, is this neighbourhood has a bright future. If we can reasonably expect that rents will outpace inflation in the future, this condo can be sold at a premium compared to what its current rent justifies.

The gentrification premium is in many ways speculative but is based on one's reasonable expectation of future inflation-adjusted rent increases. It is not absolutely certain a neighbourhood will gentrify. It may start looking better but perhaps rents don't increase like we anticipated. Perhaps the drug problem persists or other neighbourhoods are offering competition keeping the rents down. The gentrification premium here was not justified because rents did not increase as expected and we are left with unfounded speculation.

Notice the gentrification premium is about anticipation of rent increases. A neighbourhood that is gentrified but not expected to gentrify more would not have a gentrification premium.

An important point is that gentrification can apply to a city as a whole or to its individual neighbourhoods. It is generally true that Vancouver commands a premium to live compared to other Canadian cities but only as it relates to incomes (the ability to pay) and income-to-rent ratios (the willingness to pay). In other words people are willing to pay a larger portion of their salaries towards accommodation in Vancouver than in other regions of the country and/or, possibly, only the more affluent can afford to live there. These two factors can be due to many reasons including cultural ties, climate, ambience, high paying jobs, whatever. If we think that the city's FUTURE desirability will increase and people are willing to pay MORE of their incomes towards accommodations than is currently the case, and/or that incomes are generally set to rise above inflation, Vancouver can carry an aggregate gentrification premium. The data I have seen make this thesis sketchy. Incomes and rents have tracked each other quite closely over the past 25 years and real incomes and rents are at best flat.

If an individual neighbourhood gentrifies and a city's overall rent and income trend is flat, as seems the case in Vancouver, it has important implications for the gentrification premium. Stated bluntly, the sum of all gentrification premiums must sum to zero. For every neighbourhood that is truly gentrifying, to balance the books, there must be another neighbourhood experiencing the opposite, at least in terms of rents. Keep that in mind when touring a sample of neighbourhoods.

Now it could be Vancouver is collectively becoming higher quality without income and rent increases. I applaud such efforts to increase quality, akin to a war effort in a way, and this could well lead to higher rents and incomes. However high quality is based upon producing real value such as vibrant neighbourhoods, workmanship, effective facilities and services, low crime, and sustainable and productive employment; not a quick paint job and a two week vanity party. There is, though, a justifiable premium should residents collectively make the city into something greater than it is today, as measured by income and rents sometime in the future.

Also note that gentrification and densification can go hand-in hand. Densification is generally about increasing land productivity by increasing the number of dwellings where gentrification is increasing land productivity by improving its quality. Often both occur at the same time but not necessarily.

The takeaway from the subject of gentrification is that for a property to have a gentrification premium, one must reasonably expect rents for the same property to increase more than inflation, by way of improved desirability, income growth, or both. The anticipation of the city's future greatness is what has led many to justify paying a speculative premium for Vancouver property and this premium is certainly priced in, in spades. At some point -- and who knows when -- the promise of greatness needs to be delivered.