How the Surge of Hot Money Pushes San Francisco to the Brink

The median home price in my beloved and crazy San Francisco – that’s for a no-view two-bedroom apartment in an older building in a so-so area – after rising 13.3% from a year ago, hit an ultra-cool, slick  $1,000,000.

It made a splash in our conversations. People figured that nothing could to take down the housing market. Yet, as before, there will be a devastating event: the moment when the billions from all over the world suddenly stop raining down on San Francisco.

Every real-estate data provider has its own numbers. The Case-Shiller placed the peak of the prior bubble in “San Francisco” in June 2006 with an index value of 218, well above the current index value of 191. Though named “San Francisco,” the index covers five Bay Area counties that include cities like Oakland and Richmond where home prices, though soaring, haven’t gone back to previous bubble peaks.

The $1,000,000 that DataQuick, now part of CoreLogic, came up with is for the actual city of San Francisco. In the data series, San Francisco’s prior housing bubble peaked in November 2007 when the median home price hit $814,750. People thought this would go on forever, that San Francisco was special, that the national housing bust would pass it by. A month later, the median home price plunged 10%.

It was the beginning of a terrible bust – the moment when money from all over the world stopped raining down on San Francisco. Real estate here lives and dies with the periodic storm surges of moolah from venture capital investors, IPOs, and corporate buyouts.

Now we’re in another storm surge. The Twitter IPO transferred billions from around the world to Twitter investors and employees in the city and the Bay Area. When Facebook acquired Whatsapp for $19 billion, its 55 employees and some investors started plowing some of this money into the local economy, money that didn’t come from heaven but indirectly from Facebook shareholders. In the current climate, hundreds of transactions, large and small, take place every month, including a slew of IPOs. That’s the great hot-money-transfer machine. And San Francisco sits at the receiving end.

There are some drawbacks, however. Number one, it won’t last. It just prepares the way for the next bust. Number two (and in the interim), it forces out real businesses with real revenues and profits. And it drives out people who find themselves – though well-employed – financially unable to live here any longer.

Take the story of Bloodhound that was catapulted into the limelight by ValleyWag. In January 2013, a Series A round brought its total funding to $4.8 million, based on its conference app, an “ambitious vision to fundamentally change how buyers meet sellers,” as TechCrunch put it. “Its hardcore dedication to product and the fact that it can reuse everything it builds puts it leagues ahead of….” Etc. etc. The article was dripping with startup hype.

Companies like Bloodhound are flush with money from investors and have no need to make revenues or profits, and they have no clue how to manage expenses, or that expenses even need to be managed, and there’s nothing to constrain them in any way and force them to be prudent with investors’ money. Armed to the teeth this way, they dive into the local real estate market.

As the startup bubble in San Francisco was coming to a boil, and billions started showing up in bits and pieces, landlords began lusting after this money. And so in October 2012, the Million Fishes Art Collective – “an incubation program” for artists – was not able to renew its lease on a 10,000 square-foot space on Bryant Street at 23rd Street, in the Mission, which had been an iffy area and therefore affordable. After ten years, Million Fishes was gone, and so were the artists and the shows that had been open to the public. It reportedly had been paying over $13,000 per month.

The space was prepared for a startup armed with hype, hoopla, and Series-A money piped in from VC-fund investors around the world. Along come Bloodhound with whatever remained of its $4.8 million in funding. It signed a 5-year lease for $31,667 a month in rent and $564 in fees, or nearly 150% more than Million Fishes had paid. The neighborhood wasn’t amused, but hey, big money rules, and it was a done deal.

So Bloodhound was blowing $387,000 a year on rent, and it didn’t care because expenses were no objective because profits weren’t even on the horizon. It was just building a thingy that would forever change the world. But now Bloodhound is gone as well. Stopped paying rent, ran out of money, just packed up and disappeared. ValleyWag reported:

When emailed for comment, Bloodhound co-founder Anthony Krumeich simply stated “We moved out of the office. No longer fit our needs.” However court documents indicate Bloodhound has gone AWOL and abandoned their office. The landlord’s attorney has not been able to issue the company or its founders a summons….

Bloodhound didn’t change the world. But its hot money changed San Francisco. It helped drive up rents. Each transaction impacts a number of future transactions via the multiplier effect. This scenario is repeated over and over. Enterprises with real cash flows are pushed out because they can’t compete with the hot money that briefly comes into town looking to multiply itself.

But occasionally, it goes too far, even for San Francisco. A little while ago, Pinterest jumped into the fray. It has raised $800 million so far, and sports a valuation of $5 billion, but has no noticeable revenues, doesn’t even dream of profits, and has no idea how to control expenses – and no need to. Armed with this distorted attitude and hundreds of millions of dollars in global hot money, it set its sights on the beautiful, historic 600,000 square-foot San Francisco Design Center at 2 Henry Adams St., where 77 design businesses were plying their trade the hard way by generating the cash flow necessary to sustain themselves.

The Design Center’s owner, according to the SFGate, “had sought to take advantage of a city zoning ordinance that allows owners of designated historic landmarks to change zoning from so-called PDR – production, distribution and repair – to traditional office space. That would have allowed Pinterest to locate its offices there.” The tenants would have been booted out in favor of a company that had no reason to care about how much money it blew on office space. Alas, after an uproar, the Board of Supervisors Land Use & Economic Development Committee voted to table the matter indefinitely.

The ratchet effect continues as each transaction impacts future transactions, pumped up by hot money that doesn’t care about actual expenses and profits. And the space Million Fishes had leased for $13,000 a month, and that Bloodhound had leased for $31,667 a month, went back on the market, ValleyWag reported, at $37,500 a month.

This too is happening to homes where one sale price of one home impacts the price on average of 60 others via the multiplier effect. That’s how we got to the median home price of $1,000,000: powered by hot money that follows hope and hype about the next big thingy that will change the world. As before, someday the hot money will suddenly evaporate, with devastating effect. To pinpoint that moment, we just have to watch the IPO market. When it blows off its top, so will San Francisco.

UBS is already preparing for that moment. The world’s largest wealth manager is “very worried” about “the lack of liquidity” that could wreak havoc during the expected sell-off. So UBS reduces risk “over the full spectrum of assets.” Read…. UBS Warns Everything Is Overpriced, Prepares For Sell-Off

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  13 comments for “How the Surge of Hot Money Pushes San Francisco to the Brink

  1. matt says:

    Now that the PBOC scam of “encouraging” the hot money to be off shored to the u s has been discovered and is being shut off I just can not wait to see how fast the Chinese investments in Real Estate dry up over the next 6 months in San Diego S F and NYC

  2. Michael Gorback says:

    The risk is compounded by the fact that many of these multi-billion dollar companies don’t even generate any profits. Twitter has 2300 employees and negative EPS. Of course, this was spun in the media as a profit after excluding one-time charges (which never seem to be one time).

  3. PKZ says:

    Great article, but I don’t get one thing. All real estates described in article were bought or rented with cash, not on credit. If there are no borrowers which could default on their mortgage, there are no risks associated with it.

    • Wolf Richter says:

      The article focused on the issues beyond the banks: real businesses are being pushed out to make room for VC-funded startups that don’t survive. But in the process, the city gets so expensive that normal business that have to make a profit cannot exist anymore.

      And even if these startups get bought out – which many of them do these days – their new owners will integrate them into their own operations or just shut them down (maybe they just wanted the engineers). Suddenly, when the crash happens, which it always does, the scheme collapses.

      Banks may take losses indirectly via the landlords that mortgaged these buildings to the max when rents were high, and then the rents drop and high vacancy rates won’t support the mortgage. Venture investors take losses. Money just evaporates. People pushed out of the city don’t return. The city budget, decided in fat times, goes into the red, triggering the usual drama. All sorts of things go haywire….

      Not every crash has to lead to a banking crisis.

  4. lewy14 says:

    So. Awesome screed.

    I suppose when you write about investors in companies like Google, Facebook and Amazon which took very, very deep dives on their J curves before they came up and started making money, you’ll talk about “obscene windfall profits” or some such pricing the workin’ man out of something or other.

    That way you can cover the whole spectrum of VC portfolio outcomes with invective.

    I invest in startups. I have lots of friends and colleagues who do, and I’ve studied and learned from those whose games is way above mine. Let me tell you – “investors who don’t care about profits” is just rhetoric. Just myth. Just a strawman.

    I mean you can stick with it if it works for you but if you want to do yourself a favor, don’t mistake it for the truth.

    The real estate problem is very real – I was priced out of my own home town during a bubble of a prior era, despite a couple of fancy engineering degrees. I get it. But there are people commenting with less polemic and more insight on the whole tech scene, if you’re interested.

    • Wolf Richter says:

      I’m not sure you noticed: neither angels when they fund startups initially nor VCs when they do a Series A set profits as a goal. It’s not even part of the discussion. They worry about all sorts of milestones, but not profits. At that stage, often not even revenues. It’s too early. These companies don’t have their product yet.

      Angles and VCs hope to make their (big) money in an exit, so when a big corporation buys the startup or when it goes public.

      Almost by definition, when a startup needs outside money, it’s because it wants to develop its product and grow without having to worry about profits.

      Conversely, if you invest in startups, your goal is to exit in a few years at a decent multiple (rather than worrying about profits).

      So I’m not sure where you get your ideas.

      • lewy14 says:

        “So I’m not sure where you get your ideas.”

        Like I said, by investing in startups. Many hundreds of meetings over the last five years. “These guys are great! They’ll never make any money for themselves or shareholders or potential acquiring companies, but I’m sure we can flip them to the next greater fool!” said nobody I know or deal with. Ever.

        “Companies like Bloodhound are flush with money from investors and have no need to make revenues or profits, and they have no clue how to manage expenses, or that expenses even need to be managed, and there’s nothing to constrain them in any way and force them to be prudent with investors’ money.”

        Bull. There are boards. There are information rights. They work much better than those of public companies, thanks very much. I have at least one phone number for every investment I have that I can call and find out what’s going on. And I do. But the biggest “force for prudence” if you will is that idiot spendthrifts don’t get funded. At least not by anyone I know.

        If you want to put it out there that this money gets spent without oversight – that is simply untrue.

        Why do you say this stuff? You don’t even need to. There is a sadder case than the one you are making: it’s not that the money Bloodhound spent was a poor decision, it’s that hey, maybe it wasn’t. Maybe it was responsible and done with the full knowledge and consent of the board.

        This isn’t “hot money”. It’s not liquid – that’s kinda the definition of any kind of private equity.

        Is it a bubble? Maybe – what isn’t these days? And with arbitrage connecting all markets, does money even have a choice?

        The scary idea is not that emerging tech is overvalued, the scary idea is that in a world of central bank driven asset inflation, emerging tech is a great value. Sure, there are some outlier valuations that get a disproportionate share of the media. And one belly flop makes a great blog post. But it’s a poor proxy for the larger phenomenon that is modern seed/VC stuff.

        Go read Venkatesh Rao if you want to know what erudite, high fidelity cynicism looks like.

  5. Bill Chestnut says:

    This is a marvelous article. It is a marvelous piece of writing. Thanks for giving us a such a clear sense of what is going on in the markets in S.F. and your very thoughtful insights about it.
    I first read this article on Zero Hedge, and as a long time and faithful follower of Zero Hedge, I noticed something very different about the comments attached to it there. Normally there is a sort of wise-cracking, peanut gallery offering responses to every article, all hugely witty and entertaining, of course, but frequently very flippant in tone. Your article drew some of the highest caliber responses I have ever seen on Zero Hedge. There was insight, there were personal testimonials, there was much expert comment, but there was virtually no wise-cracking or flippancy. There was a serious tone of full agreement and an in-kind contribution from every commenter that said “you got it right Wolf – you are spot on with this one – ”
    Thanks for your piece on S.F. It is a pleasure to read your columns.

  6. The attitude that profitless venture-backed startups are to blame for housing bubbles is myopic for a few reasons.
    1. To assume this hot money is the province of bullshit companies ignores the biggest wealth generator of all time, Apple. That cash has had more impact on local housing than the *total* of all local IPOs in the last decade. Add the cash from just GOOG and it dwarfs startup wealth.
    2. The real problem for SF/SV housing prices is chronic shortage. Controlling for demographics, suburban Chicago has 10x properties available per capita and Dallas has 30x. Chronic shortage implies that properties will be chronically unaffordable. (shortage is due to tax laws and restrictive zoning). Don’t blame demand. Blame supply.

    Yes it’s an economic boom, and that translates into housing demand. Just like the Govt in Virginia, Oil in Houston, and Hedge Funds in Manhattan. When that boom subsides, demand will subside and prices will correct. They always do. (The 2002 tech recession was WAY worse on SV home prices than was 2008.) But to blame shitty startups is to miss the dynamic entirely.

    • Wolf Richter says:

      No one is blaming startups for what’s going on. This article is about the Hot Money and the mechanism and players by which it enters the SF economy from around the world, and what that Hot Money does to office rents and home prices.

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