Most insightful hour in CRE! Dr. Peter Linneman on rates, inflation, global tensions, and more

07/20/2022

Willy is joined by Dr. Peter Linneman for their quarterly update conversation. Before diving into the discussion, Willy shares highlights from the Walker & Dunlop Summer Conference and the annual Marshall Bennett Classic. Segueing into the latest Linneman Letter, which begins by listing the problems confronting the U.S. 

The U.S. economy, Peter believes, is a powerful force that will keep going no matter what. It is a remarkable achievement that the economy is 3% larger than it was before Covid. What could potentially go severely wrong would be if we got waging price controls, if the war went nuclear, and if the war spilled over into other NATO countries. There is also the chance that we could be taking ourselves into a recession. 

Though inflation is currently higher than Peter and the Fed previously thought it would be, he still does believe that it is transitory. With 23% of the labor force collecting unemployment insurance, it isn't surprising that supply has not yet caught back up with demand. China is still shut down in some places, making manufacturing expansion more difficult. Additionally, shipping, freight, and oil prices are down. Peter predicts that oil prices will come down below 80 within the year as supply adjusts. People often lose sight of how quickly supply adjusts. As Europe looks to the U.S. for goods and services, it could add 40-80 basis points of GDP growth to our economy. The U.S. is good at weapons and weapon systems and didn't previously do much trading with Russia or Ukraine. The U.S. is the second largest producer of oil in the world. The American industries of farming and energy are ones Peter has confidence in. 

Even if the Fed gets rid of $5 trillion on its balance sheet over the next five years, Peter thinks it won't be a shock because there is enough liquidity in the market to absorb it. On the monetary side, there has been so much recent capital pumped into the system sitting on both the consumers' and state balance sheets. The Fed is unlikely to be able to control this as it relates to long-term interest rates. The globalization of money has made this even more difficult. Since the beginning of the pandemic, the M2 is $6 trillion higher, $5 trillion of which sits in cash and is not circulating as wealth. Peter does not see the 20% national debt to equity ratio to be of concern now. He reveals that he has never been concerned by the federal debt but rather by whether or not we got our money's worth. At a national level, the debt U.S. citizens owe themselves is neutral at a national level, but not on a personal level. The higher personal debts become, the more politicized the issue.  

Of the 20 economic indicators the Linneman team tracks, 15 of them are currently beating trends. Corporations have $1 trillion more than normal in cash, while households have $4 trillion more than normal in cash. This means that overall, the country is still relatively restrained. The first quarter GDP was negative, and over 1 million jobs were added, meaning we didn't shrink. As Peter has always said, cap rates don't adjust based on interest rates but on capital flows. In The Linneman Letter, he states that the cap will go down by 2026. Banks are not lending now out of fear, even though there is enough money to do so. The strength of the dollar right now is increasing the incentive for foreign capital within the U.S. 

The report also demonstrates brick-and-mortar retail stores are doing surprisingly well in contrast to online sales. On the multi-side, Peter predicts development well above trend. He points to the return to major coastal cities after many people sought real estate in middle American sub-markets during the last few years. As the episode draws to a close, Peter identifies why the Biden presidency is so unpopular.

Key ideas:

0:48 Willy welcomes guest Dr. Peter Linneman. 
3:48 - What could currently go wrong? 
8:29 - Breaking down the transitory inflation. 
14:49 - Discussing oil prices. 
16:27 - The American industries Peter has confidence in. 
19:53 - Can the Fed control the new capital? 
25:30 - Is the national debt cause for concern? 
30:27 - Peter’s thoughts regarding economic indicators. 
36:27 - Trends around cap rates and lending. 
43:12 - How the strength of the dollar is affecting foreign capital. 
45:34 - Peter’s stance on in-office work
53:48 - Shifting trends for American real estate submarkets. 
56:19 - Why is the Biden presidency so unpopular? 

Webcast transcript: 

Willy Walker: Welcome everyone, to what has now become a pretty regular quarterly update for Peter and me to touch base and see where things are in the world around us. Peter, always great to see you and thanks for joining me yet again. Let me do a quick intro on a couple of things before we dive into our discussion, Peter. 

I've had a pretty busy week with the Walker & Dunlop Summer Conference here in Sun Valley, Idaho, where I interviewed Gonzaga University head basketball coach Mark Few. Legendary actress Jamie Lee Curtis and then I interviewed four-star Admiral James Stavridis at the Sun Valley Writers Conference on his leadership career and his new book. Now I have you today, Peter, and I will tell you, you were right there with a legendary coach, a legendary actress and a legendary admiral with regard to insights and lessons to the world that we live in. 

You and I missed one another in Chicago a couple of weeks ago at the annual Marshall Bennett Classic. Those discussions are confidential and so I don’t want to tribute any of my comments to specific individuals yet just talking thematically. The conference was kicked off by a couple of billionaires being extremely pessimistic about the world we live in today and saying if things are bad today – they're only going to get worse tomorrow. I did remind myself that the group of billionaires who stood up and made those comments have rarely given me anything of optimism to think about whether assets are doing well or doing bad. So, I do put a little bit of a caveat on that. But we went into office where there's clearly a dichotomy between class A office and everything else. We went to retail where one of the large retail REIT CEOs stood up and said, “We survived COVID. We're trading at a seven and a half cap. You can still put positive leverage on retail, let's go!” which I thought was pretty great. The next day we turned to multi and industrial. And as you highlight in The Linneman Letter, Peter, multi and industrial as far as performance characteristics today are about as good as we've ever seen them and both are very much sort of the most favored asset classes and both from a performance standpoint are doing exceptionally well. There were a couple concerns about Last Mile Industrial, where Amazon and some others are pulling back from Last Mile in distribution at the local level. And then there were some comments about concerns about tenant risk on life sciences. Life sciences has been an asset class, Peter, as you've written about, that's been incredibly strong and there were just some questions as it relates to whether venture dollars will continue to flood that space and that really in investing in life sciences and medical offices, you got it for the first time in a while be really careful about the tenant base. 

After a pretty pessimistic first day, I would say that most people left thinking that the sun would actually come up the following day. And I very much look forward to seeing you back and hosting that meeting a year from now. That's a pretty good segue way into The Linneman Letter this quarter. You begin by listing a litany of problems confronting the U.S. like polarized politics, COVID, war in Ukraine, deficits, global warming, etc. But as you typically say, Peter, “Don't bet against the U.S. economy.” This morning I got my New York Stock Exchange daily update and it said markets are a little lower after yesterday's 2.4% gain on the DOW. 50 S&P 500 companies have reported earnings so far and 70% have beat expectations. The MBA reported mortgage applications fell 7% this week and were 19% below a year ago, which actually surprises me, given the flurry of mortgage activity a year ago. But that mortgage demand is now at a 22 year low per the Mortgage Bankers Association. WTI crude back below 100 bucks a barrel and the ten years down six basis points to 296. So, my question to you, Peter, is what could go wrong? Not hearing you, Peter. You're on mute.

Peter Linneman: There we go. Sorry. As always, I say my best things when I mute it. (Laughs) Right. So, I chose my background today as a photo I took at Niagara Falls from the American side a few years ago. That's the most powerful waterfall in the world, and it's a good analogy to the U.S. economy. It's powerful, it keeps going. There may be times when it's a little slower, but it keeps going. What the U.S. economy achieves is pretty stunning and the wonderful thing about real estate is we're in the long-term business world. We're not in the business of the next six minutes or the next six days. You mentioned the litany, and one of the things I pointed out is there's always been a litany. I'm 71, you're younger. But every day of your life, you could make a litany of things wrong with the U.S. economy and they really are things that are wrong. The economy is 3.5% bigger than it was before COVID, before the social unrest, before the contentious elections, before all of this – what a remarkable achievement. Yes, it could have been larger still. What could go wrong? 

Interestingly, I don't think it's politics that go wrong because pretty much the entirety of my 71 years, the politics have been miserable. That's just what they are, and yet we go forward. What could go wrong that is really severe is if we got wage and price controls. Nixon imposed them in the 70s, they didn't do anything to inflation. They did distort resources enormously and dragged the economy down. Second, we have a nuclear power at war, in a real shooting war. And if that somehow went nuclear, that would be an all bets. I mean, that's not occurred. And I don't know how the world would react to it. And the third is, if that war spilled over into Poland, the shooting part spilled over into Poland or into the NATO countries – that would be very, very upsetting. A consensus that we're going to talk ourselves into a recession. And it seems that that does seem to be coming from the Republicans wanting to use their media to point out how badly the Democrats are doing. They don't need help, and the Democrats have apparently decided to kind of blame everything on Biden. He doesn't need help. And so, the entire media is trying to talk us into a recession. They are creating nervousness. But I think right now, where we're at is another moment of fear, conquering greed. Right? And that happens. What's the lesson we've learned from history about when fear conquers greed? Not for long. Not for long. I just remind people, go back to March 2020, that was fear. Would you agree? I mean, real fear. And you came back a year later and greed was back. And I don't mean greed in a negative, nasty sense. I just mean, you see all the good things that can happen rather than all the bad things. We can think of fear, you think of all the bad things that can happen. And greed is when you think of all the good things. And there's a balance out there, more good than bad. So, there is a slight chance we're going to talk ourselves into a recession. 

Willy Walker: So first of all, I'm getting a bunch of latency off of, I think your end of it. So, it's anyone listening in who's hearing the delay on Peter's side, hopefully that will get better as we go along and his connection speeds up. 

Peter Linneman: Let me try to change the Wi-Fi here while we're doing that. Go ahead. 

Willy Walker: That's great. So, Peter, I want to talk about rates to start with because on our last call, I talked about the increasing rates and you essentially said to me, “hey, Willy - we’ll adjust.” I remind people that on our call a year ago right now, the ten year was at 131 and it's at 3% today. I want to also and this is one of the problems, Peter, of having such a long history with me is I take notes on everything and then I can go back and look at my notes. So let me go back to where you were a year ago as it relates to rates. And you said two things on rates and inflation: first thing, I asked you was it sounds like you agree with Fed Chair Powell that while certain inflationary pressures are impacting industries like homebuilding, what you see today doesn't concern you and is transitory. So, a year ago you were on that this is transitory inflation, not 8% inflation. On rates, you had a very bullish outlook on rates, and you said we expect short term interest rates to remain near zero for at least the next five years as the Fed replays its post-GFC playbook. I asked you five years, and here we are a year from now, and we're well off of that zero Fed funds rate. So, in this quarter's The Linneman Letter, your projection includes what you are assuming is a 75-basis point increase next week that we will have between 150 and 175 basis points added in 2022 to get us to a short term, normalized rate of 250 and a long-term normalized rate of 350. Give us a little bit of your thinking on how you're getting to a short-term rate of 250 and a long-term rate of 350.

Peter Linneman: I think the transitoriness of inflation fits in and is important to this. I still believe inflation is transitory. It's higher than I thought it would get, as higher than the Fed thought it would get. It's very interesting. When we shut down the economy, not just us, the world, right – shut down the economy, demand, and supply both plummeted. When that happened, there were only two possibilities: supply would come back faster than demand or demand would come back faster than supply. Had supply come back faster than demand, we would have massive deflation. We would have prices falling, wages falling, debt being defaulted on. Not a pretty story. And that would have been a mess to be dealing with. That was always unlikely because supply usually lags demand coming out of the bottom and when you had 23% of the labor force collecting unemployment insurance, not surprising that supply lags demand. So, demand grew, I’m just going to use GDP. So, demand grew 3% over pre-pandemic and supply lagged. What happened across the economy? Prices went up. This is real simple. Now, did they go up in some sectors more than I thought? And it's been added to by the Ukrainian situation, which nobody really foresaw, or at least no economist. There may have been military types who foresaw. 

Willy Walker: Stavridis actually said when I interviewed him on Saturday that the Defense Intelligence Agency was well ahead of the curve as it relates to what Putin was going to do, which was an interesting insight from a defense... 

Peter Linneman: That's right. And good for them. While you can look at the inflation indexes that leave out energy, they don't really leave out energy because energy inputs into everything, right. Through electricity and fuels and so forth so you can leave out oil, but you don't leave out energy, if you will. And so, it's there. So, it's higher. 

What happens? Well, I'll give you one example why do I still think it's transitory. I think it's transitory because industrial output is only 3%, not 3% annualized, but 3% in the first quarter. What's that doing? Manufacturers are saying it's highly profitable at these prices to expand output. They're doing it. Is it happening as fast as we'd like? No. China’s still shut down in major places, so it's still a problem. Chip prices have fallen. The Wall Street Journal finally figured that out yesterday. Auto sales are picking up. Why are auto sales picking up? The demand has been there, but without chips, we didn't have cars. Now they're getting chips so they're able to sell cars. Shipping rates and truck rates have fallen 15 to 20% over the last quarter and a half. Oil prices are down. They're still very high, but they're down. Let's remind ourselves about the reality of oil prices. Two years ago, oil prices were basically $20. Is it a surprise that there was a big drop in output? Huge. Do you start it up overnight? No. So I think my memory is Permian rigs went from about 480 active down to about 100 active in a matter of months. It's back up to some number like 360. Does it have a way to go yet? Yeah. When will oil prices really normalize? You want to figure that one out when production picks up. 

Willy Walker: But on that, I've got a question for you on that, because there was a Truist analyst who was on CNBC on Monday, and he said in the most matter-of-fact way, “I can see oil going to 130 bucks a barrel. And it wouldn't surprise me if it gets to 160.” He says that and nobody reacts to it, and I'm sitting here listening to him say, “I wouldn't be surprised if it goes to 160.” I'm saying to myself, the Dow is at 25,000, at 160 bucks a barrel. I mean, in other words, like it's Armageddon if we get 160 bucks a barrel. Am I correct in thinking that?

Peter Linneman: First of all, I read those kinds of reports and they get a lot of headlines, but I don't get it. If fracking is profitable at around $40, $35 a barrel, you explain to me how it can be at 160 for very long. I mean, it's just that simple. And, yes, maybe the Biden administration is not as welcoming of it, but you can overcome a lot of unwelcomeness at that kind of margin, right? I mean, it just is. And not to mention Saudi and others beat it. The other thing you're not quite right on, Willy, is people think back to the past when high oil prices were a big tax on the U.S. economy. We're the largest producer of oil in the world. So, if I said to you, Saudi Arabia, do they win or lose from higher oil prices? You say they win. If I said the Emirates, you say they win. If I said Russia, you'd say they win. Venezuela, they win. The U.S. wins. Very different than prior to when we started fracking oil, which was only about 2012, that we began fracking oil. So that changed everything in that we actually benefit, now not every citizen but Houston, Dallas, Denver, even Pittsburgh with natural gas. So, I don't think it goes that high, I would be surprised if it's above. Here's one you can write down and we can revisit a year from now: I think oil will come down below 80 within a year. And it's not because demand falls apart. It's that supply adjusts. I think people lose sight of how much supply adjusts. 

Willy Walker: And so, Peter, in this quarterly The Linneman Letter, you sort of take Europe to town on having outsourced all of their energy supply and a bunch of other things to try and look like they were the great leaders of the new green economy. And as you accurately say, they just outsource somebody else and continue to use it, they just weren't manufacturing it. And in taking them to task on that, you make a, I think, very interesting point, which is that as the world and Europe look to the United States for goods and services, as Europe falls away, that that could add 40 to 80 basis points of GDP growth to the United States economy. 

Peter Linneman: Yeah, I mean, it's pretty straightforward. We didn't do a lot of direct trade with Russia or the Ukraine. We are really good at weapons and weapons systems. You don't think Taiwan, even Germany is eventually going to buy more? Even France is going to buy more. Even Poland is going to buy more. And we aren't going to get all those sales, but we're going to get some of those sales. And by the way, I think Indonesia, the Philippines and Vietnam are going to buy more given what's the concerns about China. Second, I just said we're the largest producer of oil in the world. We're a net exporter. We'll become an even bigger net exporter and we'll gain from that. The third is people forget that Ukraine and Russia were essentially the largest exporter of calories in the world. Exporter, not necessarily creator, but exporter, and it's crushed northern Africa especially and into Central Asia from the food stocks. Well, come on, if you're a farmer in Nebraska, you're happy right now because food prices are up. You're going to plant more of whatever the highest priced stuff is. And yes, you haven't benefited so much yet because of the rotation. But moving forward, you're going to benefit. And so, when you add all that up, remember, the war is, what, four months old at this point. And so, it's easy for Germany to say they're going to increase defense spending. They haven't done it yet. Right. It's easy to say that Egypt's going to import more grain from us, but it hasn't so much happened yet. And it's easy to say we're going to frack more and produce more, but we haven't done it much yet. Now give it two, three, four years of runway. And so, I feel good about areas that are defense related in the U.S. I feel good about areas that are agricultural related. I feel good about areas that are energy related as a result of what's happening in Europe.

Willy Walker: So just one quick point on the geopolitics, because you mentioned Taiwan. When I was talking to Stavridis, he wrote a book a number of years ago, Peter, that you may have read called 2034: A Novel of the Next World War, which was a novel about the U.S. and China getting into a war over Taiwan. And I asked him, does he think that the reality of 2034 is closer to happening now, given everything in Ukraine and what China is going to be about or further away? And surprisingly, he said “further away” that everything that's happened in Ukraine makes it in his mind that China doing something in Taiwan right now actually has less of a likelihood today than it did when he wrote that book a couple of years ago. 

I just want to stay on fiscal stimulus and the monetary supply, because one of the things that I think is really interesting that you point out is you talk about the Fed shrinking its balance sheet. You talk about the amount of not only Treasuries, but also GSE debt that the Fed has. And you basically say even if they get rid of $5 trillion on their balance sheet over the next five years, there is plenty of liquidity in the market to absorb that and that that will not be a shock. Given that on the fiscal side, Peter, what about on the monetary side? There's been so much capital pumped into the system that sits on not only the consumer's balance sheet but on state balance sheets, on stimulus payments. Can the Fed control that to get to where they want to get to as it relates to long term real interest rates? 

Peter Linneman: Probably not. They can pretend they can. They've been pretending for a long time that they can. Obviously, the globalization of money, the near money that has come about versus when I was a grad student, has made that much more difficult and was always difficult. On the monetary side, if we use M2 as the measure of what the Fed did and you can use the monetary base around or M1, M2 or M3 whatever you want. Let's just take M2 because you got to pick something. The M2 since the beginning of the pandemic is basically $6 trillion higher. That went from $17 trillion to $23 trillion. The economy is about $22 trillion GDP just for a benchmark. So, $6 trillion is a lot that they added to the economy. Of that, $5 trillion just sits in cash, $1 trillion cash above normal cash. That is if you kind of tried to track what happened to the $6 trillion, you'd have found that a trillion was spent, a trillion was held by corporations as cash and $4 trillion is held by households beyond normal in cash. $4 trillion held by households in cash. That's because and it passes the smell test. We spent $1 trillion on a $20 trillion economy. So, we spent about 5% of GDP tiding us over through a really hard year. Right. Well, that kind of makes sense. The rest, we said, is wealth. It's wealth. We added it to our wealth. And it's not circulating. It's sitting in cash. It all happened so fast. It happened in a period of enormous uncertainty with COVID and otherwise, people were worried about, “Will I have enough cash?” and they've sat on it. 

Now, here's the question. Let's just take the household side, because I think it's the most transparent. If households are given $4 trillion I can understand that they hold it for a while in cash. Do you think they hold that for perpetuity in cash? I don't think so. They will allocate it more or less like they allocate all their other investments in terms of real estate, stocks, and bonds, etc.. Right? Including government bonds. So, with that $4 trillion, I would expect to see it become not a permanent extra amount of cash, but as a proportion of wealth, cash flows back to normal and all the money flows to other things. That's propping up a lot of asset prices as it moves that way. And actually, there's a theoretical foundation as to why households would have reacted this way. I mean, if you win the $1,000,000,000,000 lottery, you're going to go out and buy ice cream cones? I mean, you can't buy $1,000,000,000,000 worth of ice cream cones, so you save most of it. You have a little fun; you go buy some sundaes and then you put the rest into savings, and it grows, and you allocate it. So, there's a lot of money out there. 

That's why I took The Linneman Letter The $5 trillion, if the Fed ran off. There's $5 trillion sitting there that will be able to move out of cash and into bonds, GSEs, real estate, stocks, you name it and offset now may not be neutral because you can imagine the Fed said we are only buying certain types of assets. They only bought vanilla. You can imagine that not all the $4 trillion are going to want vanilla, but now such as the Fed sells their vanilla or doesn't replace their vanilla, some of it's going to get replaced out of the $4 trillion, but some of it is going to go into pistachios life science. Some of it's going to go into private equity, some of it. So, it's not going to be mechanically 1 to 1. Because the Fed bought vanilla. 

Willy Walker: So, on that, I want to go through this real quick on national debt, because you focus on it for a moment. It's very germane to this issue. So, you point out in The Linneman Letter that the real U.S. net wealth per capita has gone up to $452,000, $1.2 million per household, which is 15.5% above the 2019 peak. You then go on to talk about, as you just outlined, the debt burden in America, given the amount of money that we printed and that we're now up to $232,000 per household, which is up $120,000 since 2008 on a per household basis. So, on the household net worth of $1.2 million and $232,000 per household of national debt, it's a 20% debt to equity ratio. Does that concern you right now? 

Peter Linneman: It doesn't. No. It has never concerned me what the federal debt is. It is always concerned me do we get our money's worth for what the debt funded? By the way, just think of your customers, your clients. The question isn't debt, it's are they getting their money's worth? Are they getting good property that covers and so forth? And if they've got a bad property, I don't care if they got low debt, it's still a bad property. And if they've got a good property with high debt, it's still a good property.

So, the fundamental thing is, did we get our money's worth? And lots of time we don't get our money's worth from the federal debt. By the way, lots of time we don't get our money's worth from private debt, too, right? I mean, it's not unique to the federal government. The second thing about the federal debt is this is largely misunderstood. And I have a chart in The Linneman Letter that I think I'm going to do this from memory. We have about $29 trillion of federal debt. Now, remember, by the way, $22 trillion GDP is just a benchmark. However, six of that is one branch of the federal government owes it to another branch of the federal government. So, you could imagine the exercise. The left pocket of the federal government owes the right pocket of the federal government. $6 trillion. How much on net does that represent? The answer is zero, right? That's intercompany debt. That's bookkeeping. There's no real net liability there. Second is then you go with the Federal Reserve and the Federal Reserve holds and again, I'm doing from memory, Willy, about $6 trillion of federal debt. Now, technically, the Federal Reserve is an independent agency. Come on. Is it a part of the U.S. government? The answer is, of course, with some technicalities. So again, that's money that the federal government owes to another entity of the federal government. So that in itself, then you're left with about $16 to $17 trillion owed, not to the government. And of that. About $7 trillion is owed to foreigners. That's real debt. That's real, real debt. 

Willy Walker: Not if you're Argentina. But that's okay. 

Peter Linneman: Yeah, well, and that's to the point. It's real, real debt until we decide to stiff people that we've never done, and then the rest of it is owed by U.S. citizens to U.S. citizens, including somewhat I owe it partly to myself literally, my money market funds have government notes in it. I'm servicing the debt on my money market fund if you think about it. Right. Or another way to think about it, suppose your wife owes all the debt and you have to pay the tax to service it – your household's net neutral, right? So, when you think about it, the debt that U.S. citizens owe to themselves is neutral at a national level. It is not neutral at an individual level. The fact that it's not neutral at an individual level makes it an enormous political problem even though, per se, it's not economic. Why? Because I want you to pay it, right? and you want me to pay for it. So, it's an enormous, enormous political problem. And the higher the debt is, the bigger that political problem gets. So, am I worried about the debt? Let's just take the $7 trillion owned by foreigners. GDP is $22 trillion. Come on. That's not so bad. Right? 

Willy Walker: So, let me let me jump in here, because I want to get down to specifics on the markets that I want to dive into for a moment and also asset classes. But the final thing on the general macro-outlook. Your team tracks 20 economic indicators: real GDP growth, capacity utilization, medium home prices, etc. and of those twenty 15 of 20 are beating trends. Only five are behind trends. So, on that outlook, it's exceedingly strong. But on your canaries in the coal mine, a year ago you only had one canary. And anyone who doesn't read The Linneman Letter, I would say a) I strongly recommend you get it. And b) one of my favorite things to look at is the canaries in the coal mine where Peter and his team look to try and see where we are seeing anything to be concerned about, like a canary going into a coal mine. Last year you had one. This year you have six. So, we've got two dead birds on speculative real estate development. You've got one dead bird on nearing spreads and rising loan to values. You've got one dead bird on record buyout deals. You've got one dead bird on empty space being worth more than full space. And then only one, which I'm interested in, because when you went to the risks to growth, you named COVID. But on the COVID fear strangles the economy, you've still only got one bird. So, as you sit there and think about from one bird to six dead birds on your outlook, yet 15 of 20 major economic indicators you track all being above trend. Is the canary situation something we ought to be paying more attention to? 

Peter Linneman: We're early on is how I view it. When you really get in trouble is when everybody believes trees grow to the sky and when there's more money than brains. That doesn't mean that people are stupid. You could date the most brilliant investor in the world and give them ten times as much money and they'll have more money than brains. Right? So, I truly mean it. More money than brains and trees grow to the sky. Do you think we're in a period where people believe trees grow to the sky right now? No, no way. People are worried that they're going to burn to the ground, not grow to the sky. So, in that sense, I feel good. More money than brains. There's a lot of money out there. And that part is the risk. And you're starting to see it. You were mentioning life science. I believe in life science long term. I don't know how. As you know, I've written this book with Albert Ratner and Mike Roizen. You can't believe what we say in that book and not be bullish about life science long term because of what it can do to medical and life and so forth. We can talk about that a different time. But it is speculative by its very nature. Industrial, you're seeing more and more speculative. Now, it's being absorbed. There's no doubt it's being absorbed. You're not really seeing much in office. You are starting to see hotels again creeping back. They should creep back because we probably lost 10% of the hotel stock during the pandemic. So, it should creep back. But it's coming. But we are not in a period where we just have belief trees are growing to the sky. I just don't see it. Especially given the amount of... If we had cash balances below normal. Right. I'd say hmmm, people have chased everything. They believe trees grow to the sky. We just talked about it. Corporations have a trillion more than normal in cash and households have $4 trillion more than normal in cash. That's not what you do when you believe trees are growing to the sky. Right. So, they're still being relatively restrained. So, I just feel pretty good about the economy.

Two things, and you see it in The Linneman Letter, I just find it humorous that people keep saying workers aren't returning to work. And you go, well, excuse me, we've added 2.7 million jobs in the last six months. I consider that workers returning to work. Now, you may say, gee, I wish they'd return faster. And that's an interesting argument. But you can't sit there saying we're doing 400,000 jobs a month or 450,000 jobs a month, and nobody's coming to work. That's absurd. That's one of the funny things. I mean, you just don't have a recession. The first quarter GDP was negative. We didn't shrink. We did not shrink. How do I know that? You don't add over 1 million jobs in a quarter while you're shrinking. You don't have record retail sales while you're shrinking. You don't have industrial output growth 3% while your shrinking – just doesn't happen. So, I still feel good about the economy. We have a shortfall versus what we would have normally grown to versus the pandemic. We do have interest rate shocks occurring because inflation has occurred and inflation has occurred largely because of the supply lagging demand, not so much the money, because the money largely stayed in. I think the Fed got bullied into raising rates. You know, you asked earlier, how was I that wrong? They got bullied into raising rates. They really didn't want to raise rates. You saw Powell saying, I don't want to do it. But they felt… One of the horrible things, you know, it is an executive and you can only imagine what it must be like if you're under the political limelight. When things are happening, there's a tremendous pressure to do something, even if not doing much is the right thing. And we all live with that. And then imagine you're under that political spotlight. It’s unbearable, I'm sure. 

Willy Walker: So, Peter, you talk about capital flows. And one of the things you point out in this Linneman Letter is the fact of the disciplined lending that took place in 2016, 2017 and 2018 when all things were looking good, and you typically would have had lenders flooding the system with capital and underwriting standards would have gone out the window. And fortunately, lenders stayed disciplined. As a result of that and that flow of capital, as you have always said, cap rates don't adjust based off of interest rates. Cap rates adjust based off of capital flows. So, if I had to synthesize what I've heard from our clients over the last two to three months. It has been when are cap rates going to move? Because I can’t afford to put negative leverage on a multifamily asset at a 375-cap rate and put 5% debt on it. Buy an industrial asset at a 375-cap rate and put 5% debt on it. That doesn't work. And so there seems to be right now in the market, everyone saying cap rates must adjust and yet you state in The Linneman Letter it's not hard to see today's four cap declining by 10% to 3.6% by 2026. 

Peter Linneman: Lots of money. Follow the money, the $4 trillion to $5 trillion we talked about. If banks start lending their excess reserves…

Willy Walker: IF… and we're not seeing banks do that right now. Help me understand why banks aren't lending right now, because you go through in The Linneman Letter and you talk extensively about how overcapitalized the banks are, how on any ratio you could possibly look at where banks have massive amounts of liquidity. Yet just this past week, we've heard that BofA and Wells Fargo have basically said, I'm not putting capital in CRE right now. 

Peter Linneman: So, greed turned to fear – that's consistent with that. We saw a lot of money go in the banks in QE1, QE2, QE3 after the financial crisis. It took like four years for that money to really start coming out of the banks. And stress tests are what kept it in the black box. The stress tests and banks don't want to fail them. Well, we just saw all the major banks pass them recently. Now, over time, if they keep passing the stress test and they have the choice of getting 25 or 50 basis points from the Fed for leaving it unused versus getting 150 basis point spread from using it, they'll use some of it. It's that simple. Will they use it all? No. They have so much, they can't use at all. How long does it take? And that's why I say it takes time. It just takes time. There's a lot of money and even more capacity to create money out there. But stress tests and fear at the critical moment are keeping it in. You talked about last year. 

Willy Walker: They've got $5 billion sitting at the Fed, which would give you a theoretical lending capacity of $22 trillion. $5 trillion sitting at the Fed, and they could lend $22 trillion off of that. Yet we're not seeing even a trillion of it. 

Peter Linneman: You can generally think of a 6 to 7 multiple versus their reserves, and I think the reserves are 4.2 trillion or some number.

Willy Walker: Do you think something’s going on here where the Fed is talking to the OCC and other regulators and saying, look, we're trying to raise rates to slow this economy down. Whispering to those banks and telling them to stop your lending activity because we need you to partner with us on slowing this thing down?

Peter Linneman: Correct. And by the way, you may think your regulators are stupid, but you made the deal and you're going to more or less kind of take their moral suasion. I'm not saying all of that money comes out because I think the forces you're describing, but you don't need it all to come out. What if only, I don’t know, of the $4.2 trillion excess reserves, I don't know, a half a trillion of it got used at a six multiple. That's $3 trillion chasing assets! Now back to your customers, I've had interesting conversations with people, and they say, you know, I can't cover at the higher interest rate and the cap rate. You know what my response tends to be? You also could lower the amount of debt. 

Willy Walker: Which we're seeing, which we're clearly seeing, and we're doing a lot of 55% LTV deals.

Peter Linneman: Of course. Or you can get outbid by somebody who normally uses 30 or 40% debt. When you use 60 or 70%, that's another possibility. You will see lower ROE investors do better at higher interest rates. And you'll see the high ROE investors will do a little less well for the reason you're saying. I can't borrow as much, so I can't juice that ROE. So, you'll see a lot of those factors occur. There was a friend of mine who’s much older, and he was on Yale's faculty back in the day, like in the 50s, when you were paid a pittance to be a faculty member and he went to his department chairman. So, he says, and the Yale Department chairman says, “well, I can't raise your salary, son, but occasionally you have to use your trust fund.” Right. Well, he said, “but I don't have a trust fund.” The equivalent for the borrowers is you might have to use a little less debt. And in fact, if we really got sustained high inflation. Think about this. Suppose we got sustained inflation of 8% for years. Let's suppose we go several years with 8% inflation. What does that mean? That means we're going to get negative spreads. We're going to get some very negative spreads. Why? Because the dollars that are being put into real estate... My worst day is the first day and I have to pay to get those greater days where the income's growing ten years from now. So, I have to bid really high relative to today's income because tomorrow's inflated income is really going to make it up. So, you're going to get negative spreads. And we had negative spreads in the 70s because with high inflation you will get negative spreads. So of course, that makes the debt structure very difficult. You have to reconsider that debt structure.

Willy Walker: So, you mentioned that some domestic holders of commercial real estate over the last year have been net sellers by a very small amount, whereas foreign investors have been net buyers. Does the strength of the dollar right now make that an increasingly difficult play for foreign capital to get into the States? 

Peter Linneman: I think it's actually slightly different Willy. I think what the strength of the dollar is showing is how much people want to do it. It's the result.

Willy Walker: To your point, they'll hold their nose, if you will, to get into the game, get in and pay that premium. 

Peter Linneman: It's a way to view it. Bruce Springsteen I saw is touring again and I just Googled to see what ticket prices they're listing. And this is like $2,000. Well, I don't want to pay $2,000, but if you want to see it, you're going to have to hold your nose to get it. That's what's going on right now with the dollar, is that however weak you think the U.S. economy is, do you want to be in Saudi Arabia? Would you rather be in Russia? Would you rather be in Germany? Just no, is the answer. Would you rather be in Colombia, given what's going on there or Chile given on going there? So, would you rather have your money in Chile, Mexico, Venezuela, or Colombia, given what's going on? Or Miami? Right. It’s not hard. So those factors, independent of us, are making us more attractive. Try as we might, try as we might to make ourselves unattractive. 

Willy Walker: I know, we're not going to spend a lot of time on that today. So let me run through, Peter, just quickly. I want to run through some of the construction data you have and then get into your outlook on a sector basis. But I thought the construction data was very interesting and somewhat telling about what we've seen as it relates to construction capital flows over the last 12 months. And then that kind of leads into what you're seeing on Outlook by various asset classes. 

  • So, office construction down 2.6% year on year, but still 22% above – historic average. I find that to be very surprising. 
  • Industrial up 21% year on year and 75% above average –that makes perfect sense. 
  • Retail up 5.5% over the last year, but down 40% – over trend. 
  • lodging, down 26% year on year and down 27% –over trend. 
  • And then finally multi down 4.7% year on year, yet up 77% –over trend. 

So, let's start on office for a moment. You have a great line in The Linneman Letter, Peter, which says “it's hard to get growth and creativity in a remote business model,” which I 100% concur with. But you also last time we talked said once you get to 60% occupancy in office, it's going to snap back. And to be honest with you, I heard you say that, and I said Peter, spot on it. But I will tell you, as someone who has been pushing hard to get our employees back in and talking to lots of other CEOs about how do you get people back into the office, we nor anyone else from the numbers you published is even close to that 60% tipping point. And so why are you still bullish on office given the future of office is still very much a question mark in many people's minds?

Peter Linneman: That's why I'm bullish. I believe they will come back. By the way, if I'm wrong, it's not a good bet. It's that simple. I believe they will come back. By the way, I was talking to somebody from Guatemala City. Nothing special about Guatemala City – they're back up to 94%. Talking to somebody from Tel Aviv, Israel the other day, they're back up to 98%. Talking to somebody from Tokyo the other day, they're up to something like 92%. Germany is basically back up to 75% in major cities. 

Willy Walker: So, on that, though, you go back to your old model, and you say you're projecting 11.2 million new jobs over the next five years. Because of the math, what that does is it says that your vacancy rates are going to drop by 330 basis points. And Co-Star's last quarterly was at 12.2% vacancy in the U.S. office. Okay. Don't you change the model given the impact the pandemic has had on office usage? 

Peter Linneman: In the short term, yes. In the long term, I don't think so. Here's why, Willy. We're just the species, we've evolved over millions of years. I don't think a year or two changes the species that much. Now, I could be wrong. 

Willy Walker: You're right. I hope you're right. I really do. 

Peter Linneman: I've come to believe about the office sector, because you and I have spoken to endless numbers of CEOs who basically say in private, “I need my people back. I have no idea what a lot of them are doing. Yes, we've stumbled by. But to really drive growth, we got to have them back.” I'm paraphrasing and I say, “You know, you're being paid $22 million. Earn it and get them back.” By the way, if you look at the real estate firms like Owen Thomas brought his people back. He didn't have a mass exodus. He had the same kind of exodus everybody else did. I'm not picking on Owens specifically. 

Willy Walker: I got it. 

Peter Linneman: And it reminds me, I said this to a group of CEOs. You can imagine how popular I was. It was right after the NBA championships. And I said, “Steph Curry is paid $32 million to teams to make a shot under tremendous pressure, both from defense and the games on the line. And he steps up and earns his $32 million. You guys aren't earning your salary. Shareholders are paying.

Willy Walker: I would hope that there's more to determining whether someone is successful as a CEO beyond the office occupancy rate that one has in their office buildings.

Peter Linneman: But if they really believe their people are10 to 15% more productive, do the math. If you really believe they're 10% more productive in the office than not, what's that mean to profitability? 

Willy Walker: I don't hear many people talking about productivity, Peter. I hear a lot of people talking about learning, future value, and culture. It's not a productivity issue right now. I think most people are focused on learning and lifelong value, if you will, and culture. The one other thing that I would say on this and then I want to move from this to multi and industrial is just that because we learned a certain way does not mean that the next generation has to learn the same way. When I was at Morgan Stanley, I learned a lot by looking over someone's shoulder at a computer screen, showing me how to do a model. But we also didn't have Zoom for me to learn that remotely. And so, I do think there is somewhat of a trap for people of my generation and older that says, well, we learn that way, so everyone else has to learn that way. And so, I'm a big proponent of culture, productivity and everything that comes from the office. And at the same time, I think there is a little bit of it that doesn't have to be exactly as we had it. 

Peter Linneman: So, I'm going to give you one quick rejoinder that boomers can identify with: we were going to sing songs and the world would never have war again. Right. That was our view. In the sense that we were different, our generation was different. We were going to sing songs and the world would have peace. It's not been so peaceful over that time period. You don't change fundamentals. You change window dressing, but you don't change fundamentals. You may change how the desks are laid out, but you don't change the fundamentals. 

Willy Walker: You still like you still like industrial because of the transformation on the retail side of, you and I talked about this a lot, as it relates to online sales only being a small percentage of brick and mortar and brick and mortar doing surprisingly well record sales volume in the first quarter on brick-and-mortar retail. 

Peter Linneman: I wasn't surprised. I was the only person in America not surprised.

Willy Walker: Exactly. You weren't surprised by that. And you've said it and you've been on it for a long period of time. You like industrial, though, because of the multiplier effect. As you get growth in online sales, you have to have a huge amount of industrial infrastructure and you see that as a trend that continues to go. 
On the multi side, Peter, you talk through in April, May and June, more development on the multi side than we have seen well above trend, trend being at 365,000 units a year. And on an annualized basis, we've been at sort of 450 to 550 over that three-month period. But even with that amount of supply coming on, you're still bullish on multi. 

Peter Linneman: Yeah. Let's just do really quick: my numbers and I don't think they're very different from what somebody else would like Ken Rosen a quality analyst would have; my numbers are we have a national shortfall around 600,000 units. Let's take your numbers and say normally it would be 350,000 and we do 500,000. We do that for four years and we've just caught up at a national level. Now, you would then say, well, every submarket. Well, of course, some submarkets are going to overshoot, and some are going to undershoot, but we have a shortfall such that it supports it. And then when you add that on the single-family side, we have about a 3.6% shortfall in the supply of single-family homes. I mean, that's huge. And you say, well, how is that relevant for multi? That shortfall has meant that since 2000 home prices will outrun inflation just on supply demand, just on supply demand shortage. And that 3.6% is not going to disappear on the single-family side quickly. It's going to take at least a decade. Now, again, different submarkets. That's important because it means if prices are rising faster than inflation, home prices, they're probably a little outrunning income growth. And that means people have to save longer to get a down payment. And that means they have to live somewhere else, either with their parents or in an apartment longer. And that boosts the demand for multi. 

Willy Walker: So interestingly, when you talk about various submarkets, I found this to be very interesting. You like Louisville, New York City, L.A., Boston, and Orange County. You don't like Jacksonville, Raleigh, Durham, Salt Lake, Austin and Nashville. All right. So, pause for a second because Raleigh, Durham, Salt Lake, Austin, and Nashville have been the white hottest markets in the United States over the last two to three years. Period. End of statement. 

So, you now have them out of favor, and you have some of the coastal gateway cities back in favor. And just as a point on hospitality, you also put D.C., Boston, and San Francisco as hospitality markets. Are we seeing a big shift here from the smile states of the high growth sunbelt back to opportunities in the coastal gateway cities?

Peter Linneman: I think we overreacted in the mid to late 2000 teens thinking gateway was the answer to everything. And I said at the time, suburbs in the middle of the country are real. Then we had the reaction of nobody wanted to be in the cities, nobody wanted to be in the big cities. And you had that reaction and that was an overreaction as well. And you had to be in the Raleigh in Nashville. Do I think Raleigh in Nashville grow? Of course, they grow, its supply relative to demand. And in the near term, there is a lot of supply in those markets, not in every submarket in those places, but in those markets relative to the demand over the next few years. It reminds me Willy, when I entered the real estate business, I remember ULI had a survey about is such and such market good. And I thought, well, that's crazy because it depends: Are you a developer? Or an owner? If it's a great market for a developer, it's a terrible market for the owner. If it's a great market for the owner, it's probably a terrible market for the developer, right? Because nobody's building. And so, I think we're in a period where, yes, will Nashville be a long-term good place with a lot of growth? Yes, it's gotten a little ahead of itself. Short term, markets adjust and when it adjusts it'll get more back in balance. Raleigh, Durham, it'll grow, no doubt will grow. It'll grow faster than Louisville. It'll absolutely grow faster than Louisville. But there can be a time when Louisville may not grow very fast, but if supply is growing even slower. You can have a good time to be there. 

Willy Walker: So final thing, next time you and I get together will be in October, will be right before the midterm elections. You look at your number for 2022, GDP growth of 3.5%. You look at the number of jobs that you just put forth. I'm going out of focus. You look at the job growth that you just put in in the 2.6 or 2.8 million jobs over the last six months. You look at relative peace. In this call, two years ago, we were already previewing what if Joe Biden got elected and what would happen with tax policy. And you were already ahead of that issue saying, oh, if Biden gets elected, we've got taxes going up, going to be big. A year ago, it was almost all anyone wanted to talk about. And we had a lot of people who sold not only assets but sold companies due to what they thought was bankable tax rates going to go up. 

And here we come into the midterms we've had, we pretty much are assured there will be no change in tax policy given Manchin coming out last week and saying, I ain't voting for anything and anything on the tax side or anything on the environmental side. So, you're basically waiting until the midterms and the expectation is at least the House and potentially the House and the Senate flip. Why doesn't all that play into Joe Biden being a popular president today on everything else we’ve talked about?

Peter Linneman: I'm not a political pundit. I think people kind of figured it out. They didn't elect Joe Biden to be President, they elected him not to be Donald Trump. And he succeeded in not being Donald Trump. And I'm not a big political type, but as I said, Joe Biden had been rejected by his party probably quite rightly several times before, and he wasn't getting better with age. And so, it's not a surprise that reality replaced the fantasy. 

Willy Walker: My only point is I'm not trying to make a political comment about Joe Biden. And I hope that everyone listening doesn't assume that. I'm saying if you look at the data, forget about the person, forget about the war, forget about Afghanistan. If you look at it from an economic standpoint and say people vote with their back pocket, all the things’ people expected to come from a Biden administration, quite honestly haven't come. You haven't had a decelerating economy. You haven't had no job gains. You haven't had all the things that everyone was fearful of. And yet he's wildly unpopular. I'm not trying to convince people otherwise; we just simply need to look at the data.

Peter Linneman: Trump lost with the same information. If you think about it, the economy was growing, the economy was recovering very well, COVID vaccines came, etc., and he lost in the same way. And I can't quite explain it other than it seems to not have to do with the economy. In either case, because I think you're dead on. I think you're dead on that if all you did was look at the economy, Trump would have won. If all you did was look at the economy, I think Biden would win. What people are saying is, at least with these two candidates, these two presidents, there's a lot more than the economy to look at. Seems to be the case. 

Willy Walker: Yeah, I got a thousand more notes to go over. I ought to do an offline conversation with you so that 3,500 people who are still on the line can come across us. Peter, as always, fantastic to both see you and talk about all your great insight. Thank you very much for spending the hour. I look forward to doing the Mike Roizen book and your book in September and then we're going to be back with our quarterly in October. Between now and then, we will see whether banks actually decide they're going to get back into this market or not. 

To everyone who listened today, thank you for your time. I believe that we're going to replay my interview with Jamie Lee Curtis from last week, next week. And if you have any interest in listening to a really incredible discussion with one of Hollywood luminaries, Jamie Lee Curtis, tune in next week to hear that. Very different from what we've discussed today. Peter, thanks so much for your time and take care of yourself. 

Peter Linneman: Thank you. 

Willy Walker: Great to see you. 

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