Fred Wilson (New York VC) wrote a post on his blog this morning called The Bubble Question. In it, he talks about how everyone asks him whether or not there’s a tech bubble, which he has been asked for the past 4 years now. It reminded me of the debates that are also happening in the real estate community (particularly in Canada).
The thesis of his post is this:
I learned in business school that the multiple of earnings one should pay for a business is roughly the inverse of interest rates.
In other words, as interest rates drop, people are willing to pay more for the business or asset in question. And it’s because they can’t find the yields anywhere else.
The same phenomenon, you could argue, is also happening in the real estate space. Typically, income producing real estate assets are assessed using capitalization rates (or cap rates), which is defined by the Net Operating Income (NOI) of the property (revenue – expenses, but excluding financing costs), divided by the price of the property.
The real estate equivalent of what Fred is talking about is cap rate compression. When cap rates drop it means you’re paying more for the same amount of yield (or NOI). One of the reasons that might happen is because people are anticipating that the asset will appreciate. But it could also be because interest rates are so low that investors will take whatever returns they can get.
So you could argue that the market is just responding to the macro economy. And since the feds are probably waiting for global growth to pickup (before raising rates), one could argue that the status quo is just going to continue. Ideally, it’ll continue until robust economic growth is able to take the place of cheap money.