Social Capital (Silicon Valley VC firm) recently published an interesting series on (economic) bubbles: what they are, how they form, when they are useful, and so on. It’s worth a read – you can start here.

Here’s a taste:

“Prices in markets turn out to have two roles: they tell us something about the past, and they influence our actions — and therefore, their own price — in the future. Sometimes, in a big way, this dual role makes a particular asset class — tulip bulbs, railway stock, Canadian real estate, a digital token — become attractive solely because its price is going up. George Soros characterized and mastered this phenomenon, known as Reflexivity: when our views and our actions reinforce each other. If an expensive price means that something is high quality or otherwise attractive, we will tend to buy more of it and drive the price higher, independently of whether or not the thing is any good. It’s true for sunglasses, it’s true for ICOs, and a whole lot more.”

For obvious reasons I couldn’t resist posting this quote. Notwithstanding the shot at Canadian real estate, bubbles are a fascinating topic. They happen time and time again because we are greedy.

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.