Real estate private equity funds saw the amount of capital they raised drop during the fourth quarter of 2019—a potential signal that investors are having trouble

In 2000 we had an internet bubble. In 2007 we had a real estate bubble. What might be the next bubble?

This question was first asked in August 2013, almost three years ago – more time for bubbles to grow. We haven’t yet had positive confirmation of a bubble bursting.

I was knee deep in the commercial mortgage backed securities industry in 2007 and there were a number of indicators that something was amiss:

  • Prices paid for real estate started to not make any sense. I recall a London office building that was sold around 2006–7 at a yield that was 1–1.5% below interest rates (to be clear, typically there is a interest rate-property yield spread. By borrowing, levered equity returns are higher than if property was bought with 100% equity. But when the spread between property yields and interest rates reverse, it implies that the real estate is not the best application of capital.)
  • Buyers of commercial real estate were selling their properties for more than they paid within 12 months of purchasing them. No change had happened with the properties except that there was one less year on the leases (shorter remaining lease lengths, to be clear, would normally mean the property was less valuable).
  • Over a 3 year period, buyers of commercial real estate evolved from experienced active asset managers to less experienced, financial engineers who were making money on the interest rate-property yield spread and flipping commercial real estate.
  • New lenders entered the property finance market (to be clear, new lenders without experience in the property finance market).
  • Pricing on real estate loans started to contract (I should clarify, I mean the spreads the lenders were making. Underlying interest rates were starting to rise, but the increases weren’t always passed onto borrowers. Borrowers maintained the pressure on pricing and squeezed lenders).
  • Increased movement of people – whole teams were starting to move.
  • Increased M&A activity as institutions started to struggle, their share prices started to fall, and they became acquisition targets.

There are some behaviours in at least two markets that would indicate bubbles building.

US Technology Venture Capital

Some people have been attempting to predict which “unicorn” startups will die. In June 2015, Andreesen Horowitz published a presentation arguing there is no bubble (in my opinion, that is reminiscent of management saying there will not be any layoffs after a merger). Although venture capital funds raised record amounts at the start of 2016 (WSJ paywall), startup investment in leading US cities is slowing. This could be interpreted as a sign of VCs stocking up their war chests and preparing for slower paced capital deployment. In February 2016, Fidelity Investments marked down the valuations of a number of its private investments in technology companies.

  • Tech company valuations started to not make sense in recent years.
  • New investor entrants to the US tech market including non-accredited investors (new crowdfunding legislation in Canada and US) and investors from Asia.
  • A number of tech startups have announced the cessation of their operations.

Chinese Economy

There has been a rapid flight of capital from China into businesses in North America. It is also pouring into real estate, causing property prices to no longer make any sense relative to traditional analysis of fundamentals.

Prices of residential real estate in San Francisco and Vancouver, cities on the west coast of North America that are easily accessible from China, have sky-rocketed. In Vancouver, prices have decoupled from average earnings and rents. (Detached residential real estate in Vancouver, and I’m sure in other markets as well, is now a store of value, making it very difficult for the average person to buy a detached, single family home. But this answer isn’t commentary on the Vancouver real estate market. Instead I mention unrealistic real estate prices as an indicator of a potential bubble in the Chinese economy).

There are likely other bubbles building, such as consumer credit and country level economic growth, but the above two have the most obvious indicators in my opinion and are happening right on my doorstep.