I recently wrote and recorded audio commentary for Townhall Review about tech titan Peter Thiel and his move from San Francisco to Los Angeles. Here's the text:
"The investor who bet on PayPal, bet on Facebook, and bet on Trump is now betting against Silicon Valley. I’m talking about Peter Thiel and his announcement that he’s leaving the Valley for Los Angeles. For years, Thiel has been ahead of the curve when it comes to investing and culture. And now he’s signaling possible trouble for Silicon Valley.
"Thiel’s leaving because, in his words, Silicon Valley has gone from just liberal to a one-party state. They were always left-wing. Now they’re so radical that it’s hurt their ability to produce successful companies.
"A city built on the principles of innovation and openness has sheltered itself from dissent. If they’re not open to new ideas, they can’t innovate. And if they can’t innovate, smart investors and entrepreneurs will find the places that can."
I think this story is extremely important for numerous reasons. Partly it's important because it’s Thiel. He has an almost preternatural ability to spot turning points. Back when people thought that the internet was all about free, and that the only room for commerce was for companies to put their corporate brochures on the web, Thiel made the bet that eventually people would start to actually buy and sell things on the web. The result was PayPal, which was birthed back when e-commerce was barely a phrase, let alone a thing.
Then he spotted what was next: The switch from Internet 1.0 to Internet 2.0 (AKA social media). Thiel was Facebook's first outside investor. He bought 10.2 percent for 500,000 dollars. He later sold the majority, not all of it, for over 1 billion dollars.
Thiel also spotted the cultural/political shift which led to the rise of Donald Trump. He predicted the Trump win, and put money and reputation on the line. In this, he was not only correct, but correct in contrast with the vast majority of elite prognosticators.
More recently, Thiel placed a hefty bet on what might be the next major turning point in connectivity: cryptocurrency. He invested substantially in Bitcoin early in 2017, which even after recent declines still looks remarkably prescient.
When Thiel discussed his move with Fox's Maria Bartiromo, he said that Silicon Valley had become a 'totalitarian place'. If it lacks true intellectual freedom, it is probably exhausted in terms of intellectual creativity.
Whether you agree with Mr. Thiel or not, a large number of his neighbors appear to. My friend Mark Perry of The American Enterprise Institute has recently compiled data about U-Haul prices to and from San Jose. Since moving truck and van lease prices are set by the market, the ratio between the price of moving from California to some other city, and the same vector reversed (moving from a particular city to California), indicate the comparative demand for the two functions. Viewed that way the data tell a clear story:
It shows that moving from San Jose to Phoenix costs almost 11 times as much as Phoenix to San Jose. San Jose to Las Vegas is over sixteen times the price, as more and more people gamble on a move from the bay to the desert.
Thiel is not the only one who thinks that the future may be moving someplace else.
I was part of a team that helped create a new real estate investment index. A key challenge we faced was how to diversify geographically, and how to use a rules-based approach to avoid bubbles.
San Francisco stood out as being particularly overpriced. Instead of doing what REIT indices almost always do—using a cap weighted approach—we focus on economic fundamentals, using a regional weighting index we created based on the geographical distribution of highly productive people.
Los Angeles is nearly 3 times the size of San Francisco. San Francisco has higher productivity, with GDP per capita at $87k vs. Los Angeles’ $66k. But despite this, Los Angeles still has a GDP over 2 times the size of San Francisco’s, and about 1 and a half times the high-income population. Even after adjusting for productivity differences, the fact remains that Los Angeles is a far larger market that should receive a higher allocation than San Francisco in diversified portfolios. But the reverse is actually the case in market cap portfolios.
Why does this matter?
Market cap weighting means allocating more capital to markets as prices increase. That means their allocation to an overvalued market will be highest the day before the bubble bursts.
Rent growth is driven by income and earnings growth. For apartment rent to increase, potential tenants must either earn more or spend a greater share of their income on housing. There is a limit to the extent to which real estate price gains can indefinitely exceed the economic productivity gains of the people who live and work there. The median home price in San Francisco increased 24% in the last year, but per capita income only grew by 7% from 2015-16. An impressive figure, to be sure, but dwarfed by the increase in home prices. The two cannot remain disconnected forever.
It’s fine to expect a highly productive region to be expensive, but real estate prices must remain linked to the economic fundamentals that drive rent and cap rates.
The network effect of living among highly innovative and productive people is supposed to drive growth, but it can also backfire. If intolerance and groupthink suppress the independent thought that’s necessary for innovation, the same mechanism that has the potential to accelerate growth can suppress it.
For a deeper dive on approaches to real estate investing without the pro-bubble biases of cap weighting, click here.