Where do you think we are in the cycle?

picklemonkey's picture
Rank: King Kong | 1,773

I would love to hear different people's opinions on this topic. I have talked with several different people recently and many seem to think we are approaching the end of this cycle (maybe less than 12 months until a pullback). The markets are flooded with capital chasing deals and yield. The availability of aggressive financing is further motivating people to do deals now as opposed to waiting until rates eventually start to rise. Cap rates are near record lows, but this is at least partially supported by low interest rates.

On the other hand, I have heard the argument around the flood of foreign capital and the "flight to safety" as our economy continues to move along at a modest pace and other countries struggle it seems there might still be some time left in this particular cycle. In many areas of the country there is still a good deal of pent up demand for several different asset classes.

What do you think?

Comments (56)

Oct 6, 2015

I think we will see a pullback in the next 12 months, but I don't think it will be large. I think we are building a bubble in the tech sector which may (or may not) be a bubble with VC funds similar to the 90's with PE. We just can't tell yet if these companies are booms or busts truly, and it would become evident in the next year.

I see a minor/small correction (similar to what we had recently) to pull us down, but then if we are crashing it'll be in the early 20's for sure.

"It is better to have a friendship based on business, than a business based on friendship." - Rockefeller.

"Live fast, die hard. Leave a good looking body." - Navy SEAL

Oct 6, 2015

We are in unprecedented territory. I'm a student of history, and past experience generally informs about likely future occurrences. Not so much in this case. We don't really have historical precedent in the United States. We haven't had an interest rate hike since--what?--2006? And yet we've had the slowest post-recession recovery since WWII while real estate prices are 20% higher than their 2007 bubble peak. We're nearing full employment while we have the lowest employment participation rate since 1977. Nothing makes sense out there. The real estate market could collapse in a month or in a decade. We just don't know. No use speculating. We have nothing concrete in which to make informed speculation.

My group is making investment decisions based on the hyper-micro--neighborhood by neighborhood, opportunity by opportunity investment making decisions.

Oct 6, 2015

Imagine if the real estate starts to collapse around the time the tech bubble (whatever you want to call it) become to collapse as well. Shit would get real. Possibly that will be the catalyst for a tech bubble collapse, the RE market starting to break apart.

"It is better to have a friendship based on business, than a business based on friendship." - Rockefeller.

"Live fast, die hard. Leave a good looking body." - Navy SEAL

Best Response
Oct 8, 2015

the Fed is desperately afraid of a recession and is doing whatever it can to prevent the next one. I'm a student of market history so I share your frustration when looking at the past, the closest analogy I can find is the 50s and 60s, when rates were low, inflation was low, lots of consolidation of industries, and PEs were about where they are now. while there are many differences between now and then, I think the returns of the 60's (10y return 4-5% on stocks) are about what we should expect from large cap developed country stocks. the exceptions could be western europe.

one point I will clarify that you bring up is the theory that the decline in labor force participation and stagnant wage growth is a demographic issue in the US. because the main participation rate simply covers everyone who's not institutionalized over the age of 16, you include all retirees (remember, according to AARP, there are 8000 boomers turning 65 every single day), so by default you have a smaller pool of people to pull from. I suppose there's an argument to be made that as one retires, one should be entering the workforce, but I'm thinking that most of the retiring boomers' kids are already in or will never be in the workforce.

also, wages for 65 year olds tend to be higher than those for 16 year olds, so if you take 8000 high wage earners out of the labor force every day and expect 8000 16 year olds to replace those earnings, it's no wonder why there's been no wage growth. furthermore, a lot of wage growth is tied to cost of living adjustments, and since inflation has been low, COLAs are non existent.

all of that being said, there's not a whole lot you can do about it, you can't squeeze water from a stone, so I think the traditional rules around portfolio construction still apply.

/ramble

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Oct 8, 2015

slowclap +1

Oct 11, 2015

Couldn't agree more with this.

I think that savers have been kicked via the ass into the financial markets due to low rates. When you can't make a decent return in a savings account/CD, asset prices inflate. An average American is forced to take on more financial risk then they ever imagined. In a post-recession economy like this, the loose monetary policy has muddied the waters more than ever before. Like you said, full employment becomes trivial when people are leaving the labor force.

I'm not saying that the Austrian school is correct in its business cycle theory (or anything else, for that matter), but I think that its stance on interest rates and asset prices is an important concept to consider due to the interest rate policies since Greenspan was calling the shots.

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Oct 6, 2015

I'm more regionally focused so may have blinders on... but I don't really see a huge pullback looming around here.
CMBS spreads are all blownout and the uncertainity surrounding interest rates have made your standard commercial investor hesitant to make a move.If anything the real risk taking I've been seeing has been from local banks. Seriously, these guys are throwing around some rediculous cap rates...

I could definitely see Cross Border capital flows extending the cycle. We're just hitting record highs, well over pre melt-down levels @ ~$62B. Singapore alone pumping in $14B.

Anyways if a pullback happens within the next 12 months I don't see it being more than a moderate correction. But I'm just some dude on a forum...

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Oct 7, 2015

Your typical market cycle is 5-7 years up and 1-2 years down. Which makes us "due" for the cycle to be over. Having said so, absent any meaningful catalyst the market will continue marching on after these drops.

Oct 7, 2015

Mining: we're currently in a down-cycle due to poor industry leadership with no cost-curve support.
Oil: we're in a cost-driven inflated down-cycle, but with better cost-curve support.
Energy: Expect a shift towards de-centralized energy play?
Construction: Weak EM markets, spotty developed markets particularly US-led residential recovery.

Oct 7, 2015

For construction, how does a weak EM market effect the industry?

Oct 7, 2015

Some of the big construction companies are highly leveraged to EM markets.

Oct 7, 2015

I see the argument all the time that all this new supply is supported by increasing populations near urban centers, with strong job growth. I find myself concerned that if all these new jobs in places like Denver, Charlotte, and Austin pull back we are going to have a lot of people who can't afford to pay rent in these nice new apartments. I guess that is the risk/reward trade off. Eventually the music is going to stop, and I feel like we are closer to the end than we are to the beginning.

Oct 7, 2015

My biggest concern with the market at large is how higher interest rates will impact real estate values. A lot of this construction boom has been predicated on low interest rates (and thus low cap rates). Well, what happens when/if rates rise? Do higher cap rates scorch property values?

Oct 7, 2015

There is still exceptional demand fore core, irreplaceable assets and a willingness from investors to break through previous price per pound highs if it's the right product. That being said, assets in tertiary markets with limited upside and a clear downside just don't pencil anymore. Many value add deals just don't pencil out anymore for a couple reasons: the deal has traded between value owners and no one has "proved out" a strategy and because the asking price psf just doesn't work.

Do these factors point to a looming pull back? I don't think so, prices will plateau, perhaps, but unless a catalyst surfaces there won't be significant pricing moves. The "tech bubble" is hardly a bubble at all in comparison to the dot com era. Although we are seeing VCs slow down their funding this is something that will take 12+ months to hit the market and when it does the effects may be limited.

Someone said something about interest rates rising, which is a very real concern, textbook economics suggests that cap rates should increase with interest rates, however; research / study shows that the opposite is typically true when examining periods of rate increases. I believe Morgan Stanley did the report... Not sure.

In short, we have 1 1/2 to 2 years left. The current economic climate coupled with the evolution of real estate as an asset class results in an attractive market for domestic and foreign buyers alike.

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Oct 7, 2015

Keep money in core assets, however low-yielding they may be. The high-yield opportunities come during the trough of the cycle. Construction lending is not a space I'd like to be in right now, unless you are selectively choosing your markets.

Cap rates and interest rates have historically not been correlated, however, in this cycle I believe the excess of cheap capital flowing into the commercial property market directly because of the Fed's ZIRP and consequent down-shift in the entire yield curve...has pushed down prices, pure supply and demand. Pull the capital, cap rates will move in lock-step. Now....they will still be relatively low cap rates...at 7-7.5%...I think the days of 10% cap rates are gone.

Oct 7, 2015
sigan7:

Keep money in core assets, however low-yielding they may be. The high-yield opportunities come during the trough of the cycle. Construction lending is not a space I'd like to be in right now, unless you are selectively choosing your markets.

Cap rates and interest rates have historically not been correlated, however, in this cycle I believe the excess of cheap capital flowing into the commercial property market directly because of the Fed's ZIRP and consequent down-shift in the entire yield curve...has pushed down prices, pure supply and demand. Pull the capital, cap rates will move in lock-step. Now....they will still be relatively low cap rates...at 7-7.5%...I think the days of 10% cap rates are gone.

Cap rates and interest rates are correlated the way mortgage rates and T-bonds are correlated--it's imperfect, especially in the short-run, but long-term, it's mathematically impossible for interest rates to rise--to continue to rise--without cap rates rising just like it's mathematically impossible for T-bonds to rise long-term without mortgage rates eventually rising. Eventually you get to a point of risk-return imbalance. So to say that interest rates and cap rates are not correlated is somewhat disingenuous.

Oct 8, 2015

Irvine Properties Acq Manager I spoke with just a few weeks ago said they can't find any value add assets in their market (OC, SD, LA, SF) for Office, retail or MF. They feel it's time to build until it goes pop.

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Oct 8, 2015

Can't speak for USA although its cycle has an impact on the rest of the world but some emerging economies are growing at 5% plus.

D.I.

Oct 12, 2015

A lot of concern with over heated markets at least from a RE underwriting perspective has to do with rental rate growth and exit cap rate projections.

In the last year, I believe on the exact same asset we have seen an underwriting exit cap compression of anywhere from 50-100 bps based on the market. Our rental rate growth has gotten a lot more aggressive as the majority of buyers that we are competing against are chasing value add deals.

However, because of the incredible debt terms we are seeing right (ex 200 bps over the 5-YR treasury with 70 LTV and 100% Good news Dollars) the debt almost acts as our hedge against any market downturns.

Oct 12, 2015

You are all wrong

Oct 12, 2015

at the very beginning of a downturn that will likely be comparable to if not worse than 2008

Dec 11, 2015
undefined:

at the very beginning of a downturn that will likely be comparable to if not worse than 2008

Firmly on track...starting to see the signs appear in all parts of the global economy now

Oct 13, 2015

The mentality I am seeing now is that a rise in interest rates won't affect CRE prices. People keep telling me to look at history and they say 5 out of 7 rate hikes, CRE prices kept climbing. However, in my opinion, I do think its different this time because rates are literally so freaken low now its a joke. Who knows? We all act like economist, but its all predictions at this point. I do believe that CRE prices need to fall now or else there could a much bigger bubble in the future. What's the old saying, two in the knees is better than one in the head. We need to see a pullback in CRE and I am afraid its not going to happen at all.

Oct 13, 2015

if CRE statistics were kept back in the 40s and 50s, you can look there for guidance, rates were just as low. granted, different era, but still might be interesting.

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Oct 13, 2015
TeddyTheBear:

The mentality I am seeing now is that a rise in interest rates won't affect CRE prices. People keep telling me to look at history and they say 5 out of 7 rate hikes, CRE prices kept climbing. However, in my opinion, I do think its different this time because rates are literally so freaken low now its a joke. Who knows? We all act like economist, but its all predictions at this point. I do believe that CRE prices need to fall now or else there could a much bigger bubble in the future. What's the old saying, two in the knees is better than one in the head. We need to see a pullback in CRE and I am afraid its not going to happen at all.

It's really hard to say. I think it depends on what type of rate hike we're talking about. I think if the Fed starts raises rates 1/8 a quarter then it can ease the sector into a soft landing. If the Fed starts going at it 1/4 a quarter then who knows how things will react? Deals are getting done because rates are so low. Demand is probably being pulled forward.

Oct 19, 2015

Agreed but we can safely make some general assumptions. Numbers below might be outdated by a few years, as I'm pulling from a RE Mathematics Textbook (Lynn, Wang)

Institutional real estate is valued at approximately $4.06 T, of which, $2.94 T is debt financing, or an approximate leverage ratio of 72% LTV.

From there we can calculate a rough WACC for institutional owners where:

WACC = Return on Equity (x) % of Equity (+) Return on Debt (x) % of Debt

I stripped out the Corporate Tax rate for this example. For younger monkeys, the WACC is a rudimentary way to back into a cap rate for stabilized/core real estate. Basically this is what your investors will demand for a return, so a true "market" deal would increase in price until the lowest cost of capital won.

So let's assume:
Return on Equity = 10%
% of Equity = 28% (or 1 minus the 72% LTV)
Return on Debt = 4%
% of Debt = 72%

Calculates to a WACC of 5.66%

Applying a 5.66% cap rate to $4.06 T value, we can estimate NOI at $230 B [edit - thanks Sigan].

Holding everything constant, including NOI, and adjusting the Return on Debt by 100 bps --> 5.0%, increases the WACC to 6.38%.

Capping the NOI at this new number gives us a new valuation of $3.60 T. Thus wiping out $458 B in value, or roughly 11% of the previous amount [also updated].

This is incredibly oversimplified but thought it provides some context.

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Oct 13, 2015

The easy and immediate exchange of data is and will continue to cause massive swings in either direction. Seems like it's going to be boom and bust for the foreseable future.

Oct 14, 2015

CoStar Portfolio Strategy (CPS) had a great webinar a few weeks ago on the topic. Two economists debated Buying vs. Selling for both Core and Value-Add opportunities.

Case for Buying
-Expensive? Yes but relative value is still attractive. Yields are still well-above treasuries, 300-350 bps, and strong NOI growth projected for core markets
-US commercial RE is very attractive to outside investors, especially given stock market volatility, with liquidity in core markets provided by long line of investors looking to get in
-Interest rates will probably rise, but not by much. Bond markets predict treasuries will be below 3.8% for the next five years
-Apartments are a great hedge for inflation
-High premiums for renovations are still being realized
-Corporate profits have grown at 2X the pace of rents

Case for Selling
-Growth will decelerate, time to deleverage and save up for the next recession
-Developments to increase vacancy, occupancy gains are in the books
-35 to 40 % chance of recession (according to CPS models) by 2019
-63% of markets are above last cycle's peak
-Highest: San Francisco (28% above peak), Houston (18%), Dallas, (17%), Denver (16%)
-Lowest: Detroit (22% below peak), Las Vegas (21%), Phoenix (5%)

Overall Recommendations
-Blend and extend leases
-Lock in credit tenants
-Sell non-strategic assets
-Buy properties matching long-term portfolio needs

My personal thoughts - unless it's a compelling story, where you have a clear advantage/inside track AND you can lock in some longer debt...let other people overpay.

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Oct 14, 2015

Happen to have a replay of that?

Oct 16, 2015

Unfortunately not - the link didn't work without a CoStar Portfolio Strategy login

Oct 14, 2015

Totally depends on what kind of fund you are running. IE, I have some friends who run a fund that has 80% of their funds from european investors. Their returns in the EU are so low that they don't mind buying 2-3 caps in NYC and locking in long term debt. Better than what they will get in the foreseeable future with QE in Europe.

I think the major markets will still have foreign investors coming in for the next 2-3 years. Not only is it beating other low yielding investments, keeping $ in the US is a hedge & safety net.

Oct 15, 2015

Nobody knows. Frankly, it's unsurprising corporate profits have begun to trend off their record highs given how contractionary fiscal policy has been.

Oct 17, 2015

Your #'s don't seem to tie out? 5.66% cap rate on 4.06T of value gives you $230B of NOI. Capping that NOI at 6.38% gives you 3.6T. Still a $500B loss of value, but this is ~11% of the original amount.

By the way - a relevant research paper from MS about this:

https://www.morganstanley.com/assets/pdfs/articles...

Oct 18, 2015

OMFG! We discussed this very paper on this very site like 6-9 months ago. Do you realize that the chart actually shows that, long-term, cap rates move in the same direction as interest rates? Look at the chart in the paper on the link you provide, for God's sake!! In fact, between 1993 and 2013, there was an extremely close correlation between interest rates and cap rates. All this paper is saying is that there isn't a perfect correlation between cap rates and interest rates. That doesn't mean AT ALL that one shouldn't consider the risk that interest rates and cap rates might rise in the future. Again, look at the chart in the paper! There is a strong, although imperfect, correlation between cap rates and interest rates.

Could people on this site stop peddling this goddamn myth that cap rates and interest rates operate in some form of vacuum?

Oct 19, 2015

Totally agree with you. Our group has made two investments in the last 10 months solely on the interest rates offered - low 3.0%, fixed rate.

Oct 19, 2015
Virginia Tech 4ever:

OMFG! We discussed this very paper on this very site like 6-9 months ago. Do you realize that the chart actually shows that, long-term, cap rates move in the same direction as interest rates? Look at the chart in the paper on the link you provide, for God's sake!! In fact, between 1993 and 2013, there was an extremely close correlation between interest rates and cap rates. All this paper is saying is that there isn't a perfect correlation between cap rates and interest rates. That doesn't mean AT ALL that one shouldn't consider the risk that interest rates and cap rates might rise in the future. Again, look at the chart in the paper! There is a strong, although imperfect, correlation between cap rates and interest rates.

Could people on this site stop peddling this goddamn myth that cap rates and interest rates operate in some form of vacuum?

No one ever suggested that you shouldn't consider those risks...in fact I specifically mentioned that this cycle was particularly susceptible to these risks.

Your conclusion is directly contrary to that which the author arrives at. A 5-year correlation that fluctuates as widely as Display 2 does is hardly "extremely close". 5 years is not short term.

Either way, the point I'm making is that it's stupid to view cap rates as a function of interest rates. You should be viewing them in the context of supply & demand, which would be better measured by variables such as capital inflow/outflows, asset allocations, inventory, acquisition activity, etc. All of these variables may in turn be affected by the shape and height of the yield curve. No capital market operates in a vacuum, nor did anyone suggest that it can.

I think by assuming that tightening of monetary policy (provided it even affects long-term rates, which is not at all a given) will affect cap rates you will miss opportunities in certain markets where sheer momentum will keep valuations high.

Dec 13, 2015

Posted this article the other day. Insiders are selling shares. Institutions are selling and stacking cash. Everyone is developing in order to make money now. All indicators are that we are in the second half of the cycle.

Just announced a few days ago, Blackstone bought $2B from Greystar...add to the list of institutions stacking cash in this article.

http://www.businessinsider.com/smart-money-getting...

Dec 13, 2015

+1

Dec 13, 2015

Perhaps I am missing something.. but from what I am seeing, supply is still well below demand in most asset classes (Multi-family, CBD Office, High Quality Retail, Warehouse Distribution Industrial, etc).. so why are we saying there is a bubble? Won't prices continue to rise until supply surpasses demand? From what I am seeing, that will not be until at least 2017 in most classes, and even 2019 in some like industrial. From the sense I got, supply and demand are larger forces than incrementally higher interest rates.

Dec 14, 2015

Recently I have read a lot about an excess supply of industrial new developments coming online. Tie that into a decrease in global trade and suddenly industrial properties near coastal cities are less desirable. Additionally, a large portion of multifamily supply is driven by single person households. If there was some kind of economic slowdown these single dwellers could move in with roommates drying up the excess supply many people like to reference now. In several markets I'm active in rents are rising while vacancy is dropping signaling we are moving closer towards the end of a cycle.

I still think we have some mileage left in this cycle, but things are starting to turn slowly. IMO

Dec 14, 2015

Strongly disagree with your industrial viewpoint. The level of construction between 2008 and 2012 was extremely low (practically nonexistent). As a result, a large number of the buildings are now considered functionally obsolete and not up to today's industry standards. Over the past years, many companies have evolved and consolidated. This has forced many industrial tenants to lease undesirable space at higher rates. There is a strong need for flexible and functional space in every market. Don't believe me? Ask brokers. The level of demand far outweighs supply. The industrial demand is not driven by global trade as you may believe, but by the resurgence of US manufacturing . The growth of e-commerce has also been instrumental. Amazon is aggressively leasing space and will continue to do so considering they want to serve their consumers even faster (think Amazon prime). Btw, Amazon isn't the only one joining this trend. The demand is there and will continue to be there for the next years.

Dec 13, 2015

+1

Dec 14, 2015

I have been pretty bearish in my office in regards to the Southern California real estate market for the past year. Times are always good, until they are not. I think we are closer to the end of the cycle then not. The mom and pop developers are back in the market and the smart money is selling. Development land does not pencil anymore in Los Angeles without $3/sf+ for rents. Construction costs are increasing every 6 months. A 6% Cap to Cost is hard to find today. You better be getting a const to perm loan with a fixed interest rate. Higher interest rate, a turn in the market will ruin any return you can pinch out of a deal right now. Condos are making a return and I would not want to be in condos. People are buying up land that I know for a fact do not come close to penciling at the price per unit they are purchasing for. People need to realize that a project takes typically 2-3 years from entitlement to lease up. What kind of market will this be in 1.5 years during construction? Everyone is telling me that I "need to get into the SFH market with interest rates this low"...thats okay, I know that when everyone is telling you you MUST do something before you miss out means you definitely should not do something. I will continue to rent and be an silent investor in our in house development deals.

I would be shocked if we are not in a bad market in 1-2 years. But...what do I know.

Dec 14, 2015

For anyone new to CRE there is a lot of really good shit here. Solid way to spend an afternoon digging through all the info posted.

Dec 14, 2015

I think that we're on the cusp on something terrible.

When they raise rates (and they will soon) we are going to see the damage of stagnant wages truly affects the average person. Sub-prime auto loans are nearing highs again, as well as sub-prime credit card debt.

When the rates raise and the prices start to trickle upwards, we're going to see massive defaults not only in some of the barely above sub-prime mortgages but also:

Student Loans
Auto Loans
Credit Card Debt

Combine all of this together and you have a recipe for disaster, and honesty I think we could see a pretty harsh recession. Furthermore the tech bubble will pop, venture backed SaaS industry is going to struggle and have some really bad affects on some key portions of geography: mortgages in Silicon Valley.

I think as a nation, consumers are over leveraged and over encumbered with debt with many of those being in or some how related to the venture back SaaS boom that has been happening that past 5-8 years.

"It is better to have a friendship based on business, than a business based on friendship." - Rockefeller.

"Live fast, die hard. Leave a good looking body." - Navy SEAL

Dec 14, 2015

Real estate specific positive: Where will people be putting money in the next 1-2 years? The stock market looks like it is at its peak, savings accounts are at 1%, bond market isn't great. So, if you are a high net worth individual with cash that needs to work.... where are you putting it, if not real estate?

Dec 14, 2015

Commercial primary markets -> Interest rates will rise slowly so valuations will get get a bit sluggish (land prices will drop to equalize), but you won't see mass defaulting unless there is a shock to the economy (i.e energy blows up as credit starts defaulting as hedges expire) as banks aren't levered anywhere close to levels in last cycle. Stupid equity as well as poorly structured mezz could see the brunt of it.

Ultra luxury development is stupid and will eventually implode, good luck holding that bag - you already are starting to see sales velocity decelerate. As cliche as it sounds, there are so many non-domestic reasons primary international us markets are at current levels. To name a few: cost of capital, lack of yields elsewhere, investing in USD assets, inflation/currency hedge, etc. To be honest there are very few investments on earth as safe and attractive as prudently leveraged manhattan multi family real estate.

Buy right and structure capital properly and cycles won't phase you. Walk with the herd and you'll lose the house.

Also - walking with the herd includes 3, 5 and 7 year capital juicing out yields with io floaters. This is not the real business of real estate. It's people getting cute with opm. Best of luck to all.

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Dec 15, 2015
undefined:

To be honest there are very few investments on earth as safe and attractive as prudently leveraged manhattan multi family real estate.

Which is why REPE, and Blackstone in particular, are moving money from their riskier projects to this area

Dec 17, 2015

Was Blackstone's purchase of Greystar VII mostly core? I'm sure some of it is but $192K/door seems low, given the markets (NYC, LA, SF)

https://www.multihousingnews.com/post/greystar-sel...
The amount of pressure from LP's to deploy capital is staggering. I think 2016 will be a peak for a few different asset types. Zell made some interesting points on this yesterday

http://www.bloomberg.com/news/articles/2015-12-16/...
Anecdotally, here in the Bay Area, many tech companies are shifting focus from User Growth to Profitability, and downsizing their footprint

Dec 17, 2015
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Dec 15, 2015