Urban Economics Lab

The Urban Economics Lab at MIT focuses on studying economic activity and economic trends in cities. The Lab uses analytical models and big data to understand what makes cities thrive or decline, how housing values are formed and oscillate, and how local politics and social phenomena manifest in the context of increasing global urbanization.

Home Values and Financial Markets: Fluctuations in housing prices are relevant to wealth accumulation, labor mobility, consumption, macroeconomic volatility, and financial market stability. However, it is ex ante difficult to know when housing price movements are due to fundamentals, such as changes in the user cost of capital, versus irrational exuberance. We propose combining the canonical urban economics Alonso-Muth-Mills model and Poterba (1984, 1990) housing asset-pricing equation to form grounded theoretical expectations about the impact of changes in the user cost of capital on home values. Rental prices and rental expenditures are shown to be endogenous to interest rates, which limits the applicability of conventional price-to-rent ratios. Expected changes in home values can be expressed as simple functions of the supply elasticity of housing, and the initial share of land relative to prices in a city. The simple formula can be used to diagnose and underwrite home valuations under the null hypothesis of a common shock to the user cost of capital. Empirically, it was found that housing supply elasticities and land shares as of 1990 predicted 50% of the variance in price growth during the past boom. Deviations from theoretical growth mean-reverted dramatically during the bust period.