Are Cities with Growing Income Inequality Better for Investing?

In advanced economies, income inequality tends to grow over time.

In a past discussion about how residential real estate has outperformed equities over the past 145 years, we touched on how investment returns in an economy grow at nearly double the pace of the GDP. That means that the wealthy, whose income is largely based on returns from investments, will see faster income growth than the average employee, whose income is more closely tied to GDP growth.

There are other reasons for the expanding wealth gap, of course. Increasingly, we have a knowledge-based economy, which relies on high-skill workers. Meanwhile, there are fewer middle-income jobs available for low-skill workers, because we’ve been able to automate those tasks or outsource them to cheaper laborers overseas.

In the United States as a whole, the average income gap between the wealthiest 5 percent of households and the middle quintile (20 percent) of households grew to $308,600 between 2010 and 2015. That means that the gap widened by $58,800 over that five-year span.

Given that Silicon Valley and the Bay Area are high-profile magnets for high-skill, high-pay jobs—and considering them a real estate case study over the last decade—I wondered: Does a widening wealth gap predict real estate gains?

Here’s what I found after rooting through some basic economic data.

The Cities with the Fastest-Growing Income Gaps

First, let’s recap some quick data on the cities with the fastest growing income gaps.

Here are the ten cities with the fastest growing gaps between the wealthiest 5 percent and the middle quintile:

San Francisco: The gap grew by $142,300 (size of 2015 gap: $492,00)
San Jose: The gap grew by $122,100 (size of 2015 gap: $468,600)
Grand Rapids: The gap grew by $99,300 (size of 2015 gap: $282,800)
Austin: The gap grew by $97,100 (size of 2015 gap: $357,900)
Des Moines: The gap grew by $90,500 (size of 2015 gap: $293,800)
Seattle: the gap grew by $85,200 (size of 2015 gap: $344,600)
Bridgeport: The gap grew by $81,300 (size of 2015 gap: $691,700)
Charleston: The gap grew by $80,100 (size of 2015 gap: $302,800)
Denver: The gap grew by $80,000 (size of 2015 gap: $347,100)
Dallas: The gap grew by $77,700 (size of 2015 gap: $344,000)

And because we like charts, here’s one courteous of Bloomberg:

Now let’s switch gears and look at the income gap between the richest quintile (top 20 percent) and poorest quintile:

Surprised that the gap is smaller than the wealthy/middle-class gap? You shouldn’t be. The average member of the wealthiest 5 percent earns much, much more than her counterpart in the wealthiest 20 percent. People earning in the 80th percentile in income are normal folks who happen to have better jobs than most. They live in normal suburban homes and drive $35,000 cars instead of $20,000 cars.

People in the 95th percentile and up? These are your truly wealthy.

But I digress.

Home Price Appreciation

I gathered data from Zillow on residential real estate appreciation for the top five major cities for widening wealth inequality: San Francisco, San Jose, Seattle, Austin, and Boston. I had to skip Bridgeport and Grand Rapids, which are not major cities and for which I couldn’t find enough data.

First, I looked at the five years in question: 2010 through 2015. Nationally, U.S. home prices averaged an annual appreciation rate of 3.06 percent. Respectable if not impressive.

These top five cities averaged 7.28 percent home price appreciation each year though—more than double the national rate.

With that said, what I was really interested in was whether the widening wealth gap would predict future appreciation. So, I looked at home price appreciation for the following two years—2016 and 2017—to see how these cities compared to the national average.

Home price growth picked up, both nationwide and in these cities, as supply has remained incredibly low over the past several years. Nationwide, annual home value appreciation more than doubled. It’s up to 6.91 percent.

In these five cities, home price growth accelerated to nearly 10 percent (9.94 percent).

Was wealth inequality a predictor for greater-than-average home-price appreciation? I would argue that it was.

But that’s not the entire story, of course.

Rents

As someone who teaches rental investing, I was especially interested in how wealth inequality affected rents.

The story here proved more nuanced.

Nationwide, rents rose at an average annual pace of 2.09 percent from 2010 to 2015. In these top five major cities for the widening wealth gap? Rents positively exploded, shooting up at an average pace of 6.92 percent.

That’s over three times the pace of nationwide rent increases!

But in the following two years, the narrative shifted. Across the U.S., rents continued appreciating at almost the same pace: 2.06 percent. In these five cities, though, they fell to nearly the nationwide average—clocking in at 2.36 percent.

What happened? Why the fall back down to average?

Your guess is as good as mine. But the answer probably involves a variation of “that frenzied rent appreciation was unsustainable, and rent growth had to normalize eventually.”

Who wants to spend half their paycheck on rent? No one—no matter how much they earn (which we explored extensively when looking at how rents have slowed in major cities while seeing stronger growth in mid-tier cities).

With all that being said, if you noticed early on that the wealth gap was widening quickly in these cities, the smart move would have been to buy a rental property. Even over the past two years, these cities have still seen faster rent growth than the national average—not to mention the accelerated property appreciation.

The Backlash

Wealth inequality comes with plenty of drawbacks, even for the wealthy.

Politically, it creates a climate of anger, resentment, and crime.

Disagree? A quick look at San Francisco’s headlines over the past few years demonstrates just how much animosity toward landlords has evolved:

Then come the heavy taxes and regulation. Is it any surprise that these five cities have some of the strictest landlord-tenant laws in the country? Or high city-level taxes?

Some landlords don’t mind heavy regulation if it means higher returns. But buying before the backlash means buying without knowing how that heavier regulation will look.

Still, nothing says landlords have to hold onto their properties once the political winds start blowing angrily, right?

Should You Invest in Cities with Growing Wealth Inequality?

Income inequality is a reality of economic growth. The faster a city experiences economic growth, the faster its income inequality should theoretically also grow (barring regulatory intervention).

Why? For one reason, wealth inequality is determined by the upper limit, not the lower limit (which remains more or less a constant in the equation). In other words, income inequality jumps because Peggy doubles her income to $500,000/year, not because Bill’s income drops from $21,000 to $20,000/year.

On a citywide level, let’s use an oversimplified example of a small, post-industrial town with a struggling economy. Not much wealth inequality, right? And not much wealth, either. The richest person in town might be the guy who owns the local bank, earning $100,000/year from his little community bank.

Then someone comes in one day with the idea to convert the old fallow factory buildings to server farms for a new IT startup. They install solar panels on the roofs to power them. They invest money in hiring and bringing in a skilled workforce.

Suddenly, this company starts generating wealth in the town. And that wealth is not evenly distributed.

By its very nature, wealth is created by building companies—building something of value where before there was nothing. These companies create jobs, some of which pay well, some of which don’t. But the owners and shareholders who took a risk to build them are where the real wealth originates and accumulates.

Now the richest person in town is this entrepreneur, who earns $800,000/year. She has employees whose salaries are higher than that poor sap running the local community bank who was previously the wealthiest person in town.

If income inequality is a byproduct of a city’s economic growth (at least until the city council decides to raise taxes and regulation), then that means that wealth inequality is one more economic indicator that can help predict real estate growth.

Most people don’t like the idea of a growing income gap. But that doesn’t mean it can’t be a useful metric for spotting cities poised for faster real estate appreciation.

What do you think about widening income gap as a predictive metric for real estate gains? A useful predictor or just a smokescreen? What about the risk of backlash against high-earners and landlords?

Share your thoughts below!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.