Walker Webcast: Top Takeaways from the Best Hour in CRE with Dr. Peter Linneman


In a wide-ranging Walker Webcast conversation, renowned economist Dr. Peter Linneman and I discussed his views on monetary policy, inflation, what the economic landscape looks like for 2023, and commercial real estate. Here are some of the valuable takeaways for those watching economic developments closely.

The Fed’s Recent Mistakes

Throughout the past year, the Federal Reserve has been raising the federal funds rate faster than we have ever seen. This, of course, has led to a drastic increase in the cost of borrowing, the likes of which haven’t been seen in decades.

In just one year, the effective federal funds rate has increased from 0.08% in January of 2022, all the way to 4.10% in December of 2022. This has led many to believe that the Fed has considerably overshot where rates should be since the market wasn’t given ample time to react to each rate hike.

This rapid increase in interest rates has reduced lending activity in terms of new loans, leading to a sharp decline in demand for real estate, as well as major price corrections. Additionally, the rapid rise in borrowing costs has also led to liquidity crises for many developers and investors who locked in floating rate debt at the 2021 and early 2022 lows, as their debt obligations have been on the rise each month.

Is the Consumer Actually Faring Well?

Linneman pointed out that a key piece of the commercial real estate puzzle is always the consumer. After all, the consumer keeps retail spaces, warehouses, and offices full at the end of the day. Recently pundits have adopted the belief that the average consumer is in a bad place financially; however, that couldn’t be further from the truth, according to Dr. Linneman. He believes that the average consumer has a solid financial standing.

Oftentimes, those who believe the consumer is undercapitalized bring up the recent increase in consumer debt service payments and the decrease in household net worth. Although consumer debt service payments are rising and household net worth has fallen, it’s important to remember that the influx of stimulus in 2020 artificially tampered with these metrics.

As of Q3 2022, consumer debt service payments are roughly flat compared to 2016-2019. Additionally, even though the household net worth is down 10% from the Q1 2022 highs, this metric is still near record highs. This means that the consumer is fairly well-capitalized and should remain resilient, even in the face of a potential recession.

How Will Interest Rates Move Going Forward?

At this point in time, only the Fed chair members know where interest rates are going. However, many believe the Fed will have to begin its taper by the end of 2023. It’s difficult to predict when the Fed will begin its pivot. This is because the Fed relies on what many would consider flawed, backward-looking indicators, such as Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) index inflation.

Once the Fed begins winding rates down, Linneman believes we should see some stability in the lending market, followed by a steady decrease in interest rates until the target rate is reached. This means that now could be a great time to take advantage of the tail end of high interest rates and decreasing property values before rates wind down.

Inflation May Soon Be History

Although inexpensive capital and an overwhelming amount of quantitative easing were certainly large contributors to inflation, supply chain issues also played a significant role. Over the past year, there have been considerable improvements to the health of global supply chains. Many believe that the recent interest rate increases quelled inflation.

However, Dr. Linneman believes that the recent decrease in inflation can be attributed to increasingly healthy supply chains. He cites that it often takes six to eighteen months to see the effects of changes in fiscal policy. This means we probably won’t see the full effects of recent interest rate hikes until the end of Q1 or the beginning of Q2 this year. If mended supply chains really were the cause of the recent drop in inflation, we will likely see a sharp dive in inflation (and possibly even deflation) in the coming months.

How Will a Recession Affect Commercial Real Estate?

In the grand scheme of things, commercial real estate should remain largely unaffected by a 2023 recession. It’s important to remember that recessions are temporary, often lasting just six to eight months. As long as you have a long-term outlook on commercial real estate and you aren’t taking on excessive risk, a recession shouldn’t have much long-term impact.

In the short term, real estate professionals may have to temporarily tighten up their budgets and defer capital expenditures projects. However, there likely won’t be many long-lasting side effects of a recession in 2023. This is especially true in the case of a potential 2023 recession since the average consumer is still doing quite well.

Although those calling for a major recession in 2023 often refer to the hardships many experienced during the Great Financial Crisis of 2008, it’s unlikely a recession of this magnitude will occur.

What Does 2023 Hold for Investors?

Although the U.S. stock and real estate markets have been hit recently, the underlying economy is still strong. Inflation is steadily decreasing, the consumer is well-capitalized, and interest rates should begin to normalize in the near future. Investors and business owners alike are not out of the woods yet, but the turbulent environment we’re experiencing could bring ample buying opportunities for those who have equity and are well-capitalized.

To hear more about Dr. Linneman’s nuanced take on the market as a whole as well as in-depth market predictions, be sure to watch the full Walker Webcast.

Webcast Transcript

Willy Walker: Good afternoon and welcome to another session of the Walker Webcast with my friend, almost co-host of the Walker Webcast, Peter Linneman. It has been a true joy since the onset of the pandemic to be able to meet with Peter on a quarterly basis and discuss The Linneman Letter.

To anyone listening who does not get The Linneman Letter, I can't emphasize enough how much incredible information is inside. As you can imagine, I devour the data every single quarter so that I am briefed on what to talk to Peter about in this call. It really is a wonderful compilation of data predominantly focused on the commercial real estate space, but as everyone knows, also broader on the macro economy, which we will dive into today.

One other note, we did this webcast yesterday, we didn't press the record button, and so those who listened in yesterday got it live. We're doing it again today. And if you're listening to this on replay, you might actually have some different perspectives today than we got out of Peter yesterday. So, it'll be great.

Dr. Peter Linneman: I may even have changed opinions overnight. You just don’t know.

Willy Walker: That's exactly right. The world could have changed dramatically. So, Peter, let me do a quick summary of The Linneman Letter this quarter and then have you dive in on some thoughts. You think the Fed is messing it up pretty bad. You say, quote, “They are recklessly pursuing its policies,” unquote, and quote, “They are insane,” unquote, to seek 2 to 3% increased unemployment. You see 3% positive GDP growth in 2023, which is contrary to many economists. You reiterate long term fundamentals over short term swings or trades in the market ala Warren Buffett, you see improving fundamentals in all commercial real estate asset classes over the next five years. And on your quarterly canaries analysis, which I love and monitor very closely, this quarter you actually have nine canaries out of 50 potential living birds. Nine of them are dead now, which is almost 20%, which is, I think since you and I started doing this at an all-time high. But one of the categories where you have a lot of dead birds is a wholly new category. So, we're going to dive into you inserting a new category on the canaries in the coal mine analysis.

But I want to start with this, Peter. I've always been wildly impressed with your long-term outlook, and you focus on the data. You let the data drive you. That long term perspective has not only made your insights extremely helpful, also at times seem optimistic when others are caught up in the deluge of data and day to day swings in the market.

But right now, if somebody had listened to our webcast in Q4 of 2021 and they'd heard us talk about the fact that you didn't see inflationary pressures coming and that you thought interest rates are going to stay low forever, that person went out and bought potentially a multifamily property at a scary low cap rate. Let's just say hypothetically a 375-cap rate and he or she put floating rate debt on it, and they put extremely cheap floating rate debt on it, and they probably bought a cap, or they were forced to buy a cap on that floating rate debt. And a year and a couple of months later now the NOI that they'd underwritten on that 375 cap rate they're not getting, their cost of debt has gone through the ceiling on the floater, and they're reserving for a new cap or they've already put in a new cap because in about a year cap and they're basically underwater on the reserving for the one cap, that investor doesn't have the luxury of time right now. What should he or she be doing?

Dr. Peter Linneman: Okay. So, a couple of quick things. I was wrong about the short-term interest rate because I believed the Fed. The Fed had said we're going to not panic and raise rates fast. Shame on me for believing the Fed. I did say they were a terrible predictor of themselves. Hopefully, I've learned my lesson and I won't believe the Fed again. That's one comment.

Second comment is that, had the person (it's just not finger pointing) Had the person that you describe done further what I advised, which is if it's a more or less stabilized asset, put a fixed rate debt on it, not float and, kind of get the bargain you struck in terms of spreads. They'd be sitting very pretty right now if they had locked in their debt on a ten-year Freddie or Fannie at that moment we're speaking of, even though I was right. And I think that's a reminder. Then you say, “Okay, but they didn't.” Whether they were smart or dumb, they took their chances. They lost the bet. And you kind of advised them to take the bet. Although I didn't, I always say put fixed on stabilize. Having said that, what do they have to do? I'm reminded of Sam Zell's comment, I believe it was in 1990 when he said: “The goal is to stay alive till ‘95.” And with hindsight, if you stayed alive until about 93, you were right. I think the comment here to the party you're describing is stay alive till 2024, mid-year, something like that, shorter. But as I think we might discuss, inflation is zero right now, literally zero, probably negative right now. And eventually even the Fed will figure out keeping rates at 4 to 5% when inflation is zero to negative makes no sense. And when I say, it makes no sense, I'll put this really in bold terms for people. Should you get a four and a half percent real return for lending money to the US government for a week, that makes no sense. It's not that risky, and at some point the Fed will stumble on that, hopefully sooner than later, and you'll see the rate come down. I think the key is stay alive. Now, that means they may have to come out of pocket. They may have to seek another capital source to come in and provide a tranche of something that means they may have to defer CapEx. It may mean, all the normal kinds of things that you have to scramble on these days.

Willy Walker: To go back to Sam’s ‘Stay alive until ‘95,” let's just say stay alive until 2024 – the California system came in and put a $4 billion infusion into the BREIT, Blackstone's private REIT and propped it up after Blackstone had to put down the gates on redemptions back in Q4 of 2022. A lot of people have compared that investment from an economic standpoint to Warren Buffett investing in Goldman Sachs during the GFC as it relates to the overall return outlines and what they got. One of the comments that I have made to several people is, yeah, but it took Warren Buffett 18 months to get clarity on that we were sort of at the bottom of the GFC that Goldman Sachs wasn't going to go out of business before he decided to put that equity into Goldman Sachs and get the kind of deal he did. And it took the Cal System and Blackstone to raise the capital one month from when they put down the gates on the BREIT to go out and raise $4 billion of equity, which says to me that there is better clarity today on the other side of this crisis than there was in the GFC. Concur or disagree with me on that?

Dr. Peter Linneman: Totally agree that there's better clarity. You might also jokingly say, John Gray and Blackstone are better at creating clarity now than Goldman was then. That would not be hard to agree on. And you might also say, with all due respect to California, they're no Warren Buffett, so they may be slightly early? But I think your spirit is right. There is more transparency. What's going on is more of a lender strike than an absence of capital. When you go back to the financial crisis, you had banks disappearing all over the place. They couldn't sell loans at a loss. If they did, they were out of business. The Fed was trying to keep banks alive in all sorts of ways. Very different today. After 12 years of injecting QE1, QE2, QE3, QE-infinity raising capital standards, these major banks can sell loans at losses and not go out of business. That's a huge difference. They have money. They may not want to use their money. During the financial crisis - they didn't have money.

And by the way, you go back to the S&L era, I don't know if you're quite that old. We could get your dad in to talk about that. But during the S&L had no money, literally in the old-fashioned sense had no money. The banking system today has money, they just didn't want to use it. And just for a word on that, my belief of how it plays out, why you need to stay alive till 2024 or so, part of it is that the banks (I'm going to oversimplify this). In 2022, the first eight months of the year, the banks did about ten months of loan production, roughly. Not just in real estate, just in general. They were on track to a good year. The Fed had told them they weren't going to raise rates. The way banks do it is they make loans, package them up, sell them. These are true syndications of securitization. They may hold a tranche and then they recycle the money, hit the repeat. They were doing that and then the Fed said, “Oops, we were only kidding about raising rates.” They raised rates very rapidly and that made losses on their portfolio to the point, even though they had partially hedged, they created losses on their portfolio. If they sold those loans, there's this word they couldn't sell loans. That's nonsense. You know you could sell, it’s at what price. If they sold it at the price that would have taken to clear they lost so much money that they would have gotten no bonuses for 2022. And instead, they waited for four months, made no new loans, sat on their portfolio, made no new loans, and now they're making plans for 2023 to sell their loans at losses if they have to, and make budget. By making budget, they'll get 2023 bonuses, even though they sell at losses. Incentives matter, in other words. And they can sell at loss, just because they have enormous reserves. They know the Fed's not going to let them go out of business. They have regulatory capital. So, I must say they want to lose money, but they can't. As they sell, they'll recycle that money, and the lender strike will end, and spreads will narrow, and money will flow.

Willy Walker: When?

Dr. Peter Linneman: We see that this month, bonus targets are being set this month - by and large. And that means until those are etched in stone, no, then it's going to take a couple of months to start selling. They're even going to lend to the people who are buying loans from them. And so, I think as you move into the second quarter, you start seeing that loan portfolio rollover and recycling money. As you move into the second quarter, third quarter, you'll see spreads narrow, money come back. Now, it's not going to be a light switch, it's a dimmer switch, right. It's going to come on in that regard. But you'll see money flowing.

As you see money flowing - one other thing, Willy, back to the research and we've talked about this in several episodes. When money flows, cap rates go down or stabilize. And when money doesn't flow, cap rates move up. What we saw in the last four months has been that money didn't flow. What happened to cap rates? They went up. And people say well it was because of interest rates. No, it was because the money didn't flow. By the way, there's been lots of episodes where interest rates went up and money flowed. Even more money flowed, in fact, in history. To clarify my research, my research doesn't say that when interest rates go up, cap rates go down. All of my research shows there is no systematic relationship. Sometimes when interest rates go up, cap rates don't change. Sometimes they go down, sometimes they go up. There's no systematic relationship. And in this case, it triggered a lender strike because it happened so fast. It happened. It was more the speed than it happened. If they'd have raised the rate to the level they got to and they had done it over two years, you would not have had lending stopped.

Willy Walker: And so, if your thought is those marks, get done now, budgets for 2023 get reset and banks start coming back into the market, is it not more of a hold on to mid-2023 rather than having to wait till ‘24? Or is that too optimistic a view?

Dr. Peter Linneman: I think that's a great, great, great point. I think if you're a really preferred customer, it's more in the second quarter and if you're a run of the mill customer, it's probably into the third and fourth and that's why stay alive till into 2024 for the party you described.

Now, I will say one other thing, which is that there are a lot of deals out there, development or acquisition deals done by, or I would call traditionally fairly high leverage parties. Some people don't use any leverage. Some use fairly high leverage. And there's a lot of deals out there that are being analyzed by people that generally use relatively high leverage, that don't pencil, whether it's a development or an acquisition. And they say, well, it's marginal. And my comment to him is, is it marginal real estate or is it marginal because of capital market abnormality? In most cases, it's a capital market abnormality. And all I mean by that Willy is if you could borrow at a normal spread and you could borrow at a normal LTV, does the deal on a good piece of real estate make sense? If so, do it. And you say, yeah, but I can't get that LTV and I can't get that spread. Go get equity and use more equity to bridge yourself to the other side. Because one of the things in my career is when good real estate deals don't pencil because of capital market abnormalities – with hindsight, it turns out to have been a great time to do deals. But you need equity. And the reason it turns out to be a good time is some people get scared and a lot of people can't get equity. So, make yourself one of the people who gets equity and six months later, or a year later, or two years later or three years later, you'll adjust the capital stack and that incrementally higher capital cost for a year or two is lost in the shuffle of value creation.

Willy Walker: So, for a moment, you mentioned at the top, Peter, that inflation is essentially gone. In The Linneman Letter, you point out that the Consumer Price Index (CPI) in November was 1.3% and core CPI was 2.6%.

Dr. Peter Linneman: To make it clear, Willy, those numbers it’s annualized, not monthly. Then let me just throw in, I think it was Friday or Thursday last week, the December numbers came out and they were negative. They were negative. So, they were basically the kind of numbers you're talking about negative. So, another way, Willy, just an update on the data because it came out since The Linneman Letter is November and December had no inflation and if anything, very slight deflation.

Willy Walker: First of all, after you and I recorded yesterday, I went to lunch and I was sitting there with somebody who said, “Oh God, inflation is going up in the Fed and this…” And I said, “You need to listen to my conversation with Peter because it's basically done.” And this person's jaw kind of dropped on the floor and didn't like sort of being told that there actually is an inflation in it. And we went through exactly what you just said, which is the annualized numbers and not the changeover 2021, 2022, it was the actual print on the month of annualized basis. Talk a moment, Peter, about you go into some detail as it relates to the CPI having 42% weighting to housing and then the personal consumption index, which is published by the Bureau of Economic Analysis, only has a 15% weighting to housing. I think it is interesting that two inflation indices have such a different weighting on housing, and I guess more importantly, which is the one that the Fed is looking at?

Dr. Peter Linneman: The Fed tends to look at the Personal Consumption Expenditures Price Index. It is, you might say a little more dynamic. That is, if you think about the basket of things they buy, they're pretending they're buying the personal consumption expenditures index adjust the basket a bit more often than CPI. And the second thing is personal consumption only has 15% weighting to housing. Now, that's too low. That's way too low. Anybody living in California knows more than 15% of what you're spending is on housing. Now, if you lived in Des Moines, Iowa, that's probably pretty accurate. Right. And there's a lot of Des Moines, but there's also a lot of California’s. 42%, which is in CPI, is also probably too high. There are reasons they both do, and they all have problems. There's a long technical literature. Probably what they do, hopefully, is they move generally in the same direction. Don't get caught up in the decimal points, though I think they often do get caught up in the decimal points.

Your comment about the importance of housing is very important though, to what we just talked about November and December, because for technical reasons, that we don't need to go into, and everybody technical knows this, the housing components of those indexes lagged by about 3 to 4 months. Now, why is that important? All the other stuff is contemporaneous, but housing lags 3 to 4 months. You and I know, therefore, that November you were picking up August rent movements. Let's just think of it that way. Well, in August, month over month, rents were still increasing, but in November, month over month, apartment rents weren't increasing. So, they were putting in apartment rents that were still increasing in November when they weren't. And it understated the degree of deflation that's occurring, especially with CPI. And so, you do the same exercise in December. In December, you're picking up September's apartment rent movements, which were still somewhat positive, like two or 3% annualized, 4% annualized. And in December, in fact, I don't know, you have a broad base. Everybody gets zero or, you know, a quarter of a percent or a half percent annualized. So, the numbers of zero to slightly negative are probably a little more than slightly negative. And that's because we have had supply catch up with demand in most products, lumber, chips, you just go across the economy, ships out in the harbor, truck drivers. The only thing where we still have a notable systemic shortage that didn't exist pre-COVID. So, we have a shortage of single-family housing, but that was there pre pandemic that was not pandemic induced. The only thing we have that is pandemic induced, that's still systematically where supply lags is labor. We’re about probably a million and a half to 2 million workers short. And that's putting some pressure up on price and even that's catching up like we added like 5 million jobs in 2020. Even that's catching up, but it's still lagging.

Willy Walker: If I can jump in on that. Just there's a data point that you put in The Linneman Letter that I thought was super helpful to keep in mind. Exactly. That underscores what you just said, Peter, which was just that since February of 2020, the month before the pandemic began, we have added 1 million new jobs to the American economy. Yet, we've added four and a half million residents (they're not all citizens) but 4.5 million residents of the United States of America. And so, to your point, if you think about that, at least million to a million and a half of that delta of three and a half million should be employed and they're not employed today. And I thought you framed it extremely well in the Letter to just kind of give big round numbers that said that makes perfect sense. We added four and a half million people to the economy. We've only added 1 million jobs. There's still slack in there, even though the unemployment numbers are at historically low numbers.

Dr. Peter Linneman: Unemployment numbers are little deceivingly strong because they're not picking up that million and a half or so that aren’t, quote, looking for work. But trust me, if they find a job, they'll take it. We know that Willy because we kept having these low unemployment rates in the last year. But we added five million jobs. You would not have been able to add five million jobs if all you were doing was taking the people who said they were unemployed looking for work. That is, there were a whole bunch of people at the margin who took jobs when they came up. And the same thing is still true. That's why it drives me nuts when the Fed or the people who say the Fed needs to create unemployment are nuts. It just drives me nuts. Here we are with a labor shortage, everybody listening to this, and every industry knows that. And the solution is to get rid of jobs. And by the way, what you just said, we're a million and a half to two million short just on the population growth that occurred. And now we're going to get rid of jobs as a solution to a problem? That's just insane on its face. By the way, you add to that that every worker that goes to work on average at this point will add $60,000- $70,000 of GDP a year. I want those people. They're productive. I want them to be there when I have to have a hip replaced. I want them to be there when I travel. I want them to be there when I buy a car or repair a car. We need those people. It's what we grow. We need those people to innovate and learn. And it drives me nuts when somebody says, “Yep, we need to get more people unemployed is the solution.” And I've said to you, which is, I tell you what, when the Fed announces, we're going to start with our staff and take one for the country and get rid of 2% of our workers to help solve the problem. Maybe I could work up a rooting interest. Not really. But they continue to expand their employment. I mean, of course, they want to be productive. So, it drives me crazy, this narrative. By the way, if you go back to your numbers Willy, four and a half million people. Suppose I told you during the time since the pandemic, we've added four and a half million people and 30 million jobs. Well, you might say we got overheated. That's not the case. You know, it's just not the case.

Willy Walker: So, let's shift, Peter, to the consumer, because I think a lot of people, as they hear you talk about the Fed, what the Fed's doing, they're in many ways ill-advised or ill-targeted moves that they're making right now. But we can't do anything about it. I sort of laugh. Our mutual friend, Barry Sternlicht, seems to have a strategy as it relates to these topics of going on CNBC and sort of raising his voice as loud as he can raise it. And at some point, Jerome Powell is going to hear Barry screaming through the television screen. But my question to you on the consumer is that plenty of people are concerned that if we hit a recession if the consumer is not in a position to withstand the recession. And so, there are a number of data points that you put in The Linneman Letter that actually say that the consumer is still doing extremely well, albeit off of the post-pandemic highs. So, one of the stats that you have is real household net wealth is down 10% from Q4 of ‘21. So Q4 ‘21 was the peak. We're off by 10%, but it's still up 7% from the pre-COVID peak. And so, people kind of sat there and said, okay, normal growth, 7% on the real household net wealth up by 7%. And it's in equities and it's in home equity and it's across the board, it is in cash or still positions the U.S. consumer quite well right now to be able to withstand a recession if we have one, correct?

Dr. Peter Linneman: Correct. I need to emphasize you did it, but I need to say that's real wealth. That's real wealth that was already adjusted for inflation. So, think about it – households have 7% more wealth than three years earlier, beyond inflation. Or another way, beyond inflation, their wealth grew 2% a year. That's not disappointing. Now, it's not a home run, but it's not disappointing, we’re in pretty good shape there. They still have about three and a half trillion dollars cash beyond anything you would have expected them to have at this point based on, say, pre-COVID, pre-pandemic. They have three and a half trillion dollars cash. What will happen in the media is they'll point out that the interest burden, the debt burden of consumers is up and that delinquencies on their debt is up. But what they don't show you is it's up from a record low, and that is nowhere even near average. Now, the data lags, and I suspect that people have eaten through a little more of that cash. And when the data comes back, we'll look back to today and say, oh, yeah, they have eaten through some. The debt service is a little higher as we talk today than the data because it lags, but it's still way below normal. And so, it's not that normal is perfect – it's that normal is normal. We can have a good economy with normal.

Some people will be hurt. There's no doubt. Even in the best economy. Even at the highest wealth, there are people getting hurt and it's very sad. But we can cope. And in fact, I chose my background today. That's a photo I took some time ago and I chose it intentionally. Ben Franklin at the end of the Constitutional Congress in Independence Hall. George Washington presided and on George Washington's chair called the Rising Sun Chair. You see half of the sun. And as they ratified the Constitution, Ben Franklin famously said, “I've been sitting here all these times wondering, are we watching a rising sun or a setting sun and clearly we are watching a rising sun.” And I believe 2023 is still a rising economy; it's still a rising sun. And you can't tell by just looking at it. Remember all of these people who said we're going to have a recession in 2022? They're the same people saying we're going to have a recession in 2021, they're the same people that are saying we're going to have a recession in 2023. And even if we have a recession, the consumer is in pretty good shape; businesses are in pretty good shape. You get hit for six to eight months. Six to eight months is nothing in the evolution of a piece of real estate. You buckle down, you get rid of some inefficiencies, you pull out your hair, and you make money over the long term.

Willy Walker: So, let's dive into a discussion on some specific asset classes in the commercial real estate world. The first one I'll bring up is Office. You and I have a little bit of a difference on what we see as the future of office. I want to start with something that you put into The Linneman Letter. And Peter, you've been great at putting somewhat fantastic things into the Letter that at least make people think about what is happening. And one of the things you wrote is, quote, “It's possible the U.S. is evolving into a 32-hour workweek comprised of four, eight-hour days and a three-day weekend.” And after I wrote that down in my notes, Peter, I wrote, come on, exclamation point. And maybe I'm just too old school. And I think one of the things about that is just that my sense is that my colleagues at Walker & Dunlop and people across the industry actually are working more than they've ever worked, and that it just doesn't happen to be happening inside of the four walls of a Walker & Dunlop office. And so, I guess my question to you is, do you really think that our culture is changing to the point where the workweek might get shorter?

Dr. Peter Linneman: Yeah, I mean, remember, nationally, we're already at a 36-hour workweek. Nationally, the average is 35.4 or some number like that. Let's just call it 35 to 36 hours is the normal workweek. Of course, you all are higher, but normal is lower. Normal has been falling over time. So, if you go back three generations, they worked six and a half days a week and they worked Christmas, and they didn't think anything of it. That's what you did. Read Charles Dickens' Christmas Carol. Everybody was working on Christmas. That was the whole discussion of whether Cratchit had to come in and work on Christmas Day. It was a debate, you know. And so, as we've gotten wealthier, as we've gotten higher incomes, the developed countries and you see this even in the developing countries get shorter workweeks, that is, people would like shorter days. And it is possible that we're watching this evolve in real time, just like people saw it in real time, go from a six-day workweek to a five-day workweek. We may be watching it evolve from a four-and-a-half-day workweek, 36 hours right down to 32. And we also may be witnessing fantasy at work. The notion if I was a big company and everybody on my team had your maturity, your discipline, your work environment, your self-motivation, etc.. Maybe we could do really well remotely. And you've got a lot of such people. Now go to where you're constantly rolling in lots of young people who have never worked, who don't have discipline, etc., By the way, I'll take another. There's a reason manufacturing companies have people punch in and out. The reason is people are people. If not, they'll come 20 minutes late, they'll leave 20 minutes early, etc.. I don't think the people who work in offices are any different than the people that work in factories. At the margin, a lot of them are looking for fun. And I’ve jokingly said, Why do you think Netflix viewing is up during the day? Why do you think viewing the Price is Right is up during the day? Yes, some of it is those missing million and a half workers. There’s no doubt. Some of it is. And of course, I do it at other times.

Willy Walker: Hypothetical commercial real estate services people who happen to be at home doing something else. They are not Walker & Dunlop employees, they might be somebody else's.

Dr. Peter Linneman: They're not mine. They're not yours. They're nobody we know, right?

Willy Walker: On that Peter, the data inside The Linneman Letter that talks about office and the Moody’s came out this week with the statistic that caught my eye, which was the national net absorption of office space, plummeted from a net positive absorption in Q3 of 3 million square feet. And I read the earnings script of all my competitor firms who have big office leasing groups in Q3 and they kind of saved the quarter. And I said that is a snowball in the desert. That thing is not going to hold up. And sure enough, Q4 net absorption was a negative -7.1 million square feet and vacancies ticked up. This is back to The Linneman Letter, vacancies ticked up for the fourth consecutive quarter to 18.7% in office. So, the numbers right now for office are looking quite grim. And yet at the same time, there's over $70 billion invested in new construction of offices across the country. How can there possibly be that disconnect, Peter?

Dr. Peter Linneman: Okay. So, two technical comments: the one is, remember, the construction number also includes build out and renovation. It's all spending on office. So, it's not like it's all new buildings. Having said that, some of it is and I don't get why and I'm sure there's some build to suits out there that make sense. But I agree with you. I don't get why; I haven't advised anybody to build an office building since the pandemic began. It's a tough sector to start with. And there's a big question, I could be wrong. It's what I call the Kathy Factor. You know, I've been married for 50 years this June, and my wife Kathy, constantly reminds me: “You could be wrong.” So, I mean, there is the chance that office right now is very challenged. I think it comes out of the challenge, but I could be wrong. I don't know why you'd be building office other than if you started it, you got to finish it. But only in that sense. And there's some of that. The other thing is the big absorber.

Willy Walker: There's one other thing which you point out in The Linneman Letter, which is just that. The occupancy level for Class A new product is significantly higher. And so there clearly is something there where there are office developers saying there's an opportunity for people who want to move into the newest product with the newest amenities and that they say there is demand for that in Manhattan. Our office in Manhattan is One Vanderbilt which is arguably the nicest building in New York. You can’t get space in One Vanderbilt, so there’s this big rush to the A’s, and there may be developers, I think, who are probably thinking, I can build into that demand. It’s really going to cause even worse damage to the Bs and the Cs, obviously.

Dr. Peter Linneman: Yeah, I would agree that's fair. On the other hand, some of its commodity space that's being built as well, scattered not around One Vanderbilt obviously, but some of it is commodity space. I think that's a fair enough comment that you make, but it's not Lake Wobegon. Not everybody can be above average, right? I joke, Mel Simon was a good friend and Mel always told me how great his centers were. (David, if you're listening, you might enjoy this story.) And Mel always said, “We have nothing but A centers. All our centers are A quality.” Well, then they went public, and you got to see what the sales of their centers were. And I kind of jokingly said to Mel, “Hmmm, there's been a lot of great inflation lately.” And Mel said, “Well, you know, but ours…”and so there is that everybody believes they're above average and there are buildings that are special.

The other thing that happened in this last quarter and probably is going to continue is very interesting – tech had been taking lots of space. The big tech guys announced that they were shrinking or staying the same size, not all, but as a generic statement. So, they stopped taking space. The reason I say it's interesting is that in December and November employment data showed the information sector, which is where those tech companies are, had positive job growth in spite of the big guys announcing. So, what it meant was there was such a high demand for tech workers across the economy, including at Walker & Dunlop. Not just at tech companies that they basically got sopped up. But what did happen was the big guys suddenly didn't have the need for more space so much as two of them got hired at Walker & Dunlop. And you didn't need a whole lot more space. So, this image, or at least so far, the tech sector employment has not fallen even though big tech companies are cutting their workforce. It's a very interesting phenomenon, but it has hit leasing big.

Willy Walker: So, in office, let's just round out on that. You like San Francisco, Portland, West Palm, and Phoenix. You don't like Dallas, Houston, DC, and Denver.

Let's dive into industrial for a moment. You have pointed this out time and time again. You and I've talked about it extensively, but the industrial investment thesis underscores where retail in America is going, which is that online retail requires 3X, the industrial space per unit as brick stores do. You also, though, put the real numbers in there, which I think is very helpful for readers and for listeners to keep in mind, which is that you point out that in Q3 there was $1.5 trillion of brick retail in America. How do I size that? It's about half a trillion dollars a month on the quarter or $500 billion, and that only while growing and growing at a nice rate, only $280 billion of online retail in Q3 of 2022. And so, the great majority of retail sales still go through bricks, yet that growing component of online is requiring more and more industrial space, which has us at an extremely low 4% vacancy rate in industrial, which is down I think 60 basis points quarter to quarter year on year from ‘21 to ‘22. And so, I guess my question Peter is why isn't everyone dropping any investment they have in any commercial real estate asset class and just pouring their money into industrial?

Dr. Peter Linneman: The answer is a lot of them have – a lot of them have. If you go back, even starting in about 2018, you saw just the upswing in development and industrial beyond the kind of development that you saw in other sectors as a percent of the stock and who was doing it, what was doing it. And I think most people didn't even realize the forces driving those things you've described. And it's interesting that a year ago was about when Amazon was saying, oh, we're going to scale back and so forth and so on. And yet even during that year, absorption continued tremendously. And that's because sales are increasing online. Yes, they're a small part, but they use a lot more space per unit. The only real challenge I see is a lot of the stuff being sold online doesn't make money. And the question is how long can you sell stuff that doesn't make money? You store it. If you're going to sell it, you have to store it and handle it and so forth. And consumers clearly like to buy a lot of certain types of items online. As you point out, not most. Most are not bought online. So, you have this situation where consumers are saying, “I want it, but I don't want to pay up enough so you can make money on it.” That's going to resolve somehow. And if suddenly everything sold through bricks has to make money, but not everything selling through clicks is forced to make money. If they both were forced to make money, that would probably crimp the demand for warehouses a bit because they'd have to raise prices and that presumably would dampen the growth rate. It would still grow.

The other thing maybe as a transition, Willy, as I feel better about brick retail now than probably any time in the last decade, and I've been on boards of retail companies, and I've worried about this. And you can imagine we spend a lot of time on it. And the reason I feel better is in 2016 I was saying, but they're not making money on selling. You look at Amazon, you couldn't see in their numbers how they're making money. You get to 2019. Walmart admits they're not making money. You look at Wayfair, they're not making money, etc., but they're selling a lot online. It's one thing for me to say that but meanwhile, it's kept growing. Then the pandemic happened, and the good news for retail was it got battle tested. It really got battle tested. During 2020 and 2021, we saw what could and could not be profitably sold online and we saw what innovations could occur to make it profitably sold online. We found out groceries can't be. I mean, that was kind of the dirty secret before 2020, but it became really clear you can't sell it profitably. You can barely sell profitably in the store. And so, the question became, okay, what do you do? And there are other categories.

So, in a funny way, brick retail knows far more with far more confidence of what they're capable of doing. A lot of real companies, brick retail companies have said, I'm going to not pour quite as much money into expanding my online platform because we're not making money there. We're pouring money into something. Let's put more of that money into our stores because that's where we make money. So, I feel better about retail. It's still hand-to-hand combat. It's always hand-to-hand combat.

I learned real estate probably from among others, probably my best teacher was Al Talbott. And who was a retail genius. And his comment, I'm paraphrasing, is, “If you're in the business of satisfying American consumer preferences, you're constantly going to have to change who the tenants are” because American preferences are constantly changing and you kind of constantly have to change what products you're carrying. And that makes it a challenging business, but it makes it a good business if you've got a center where people want to be shopping.

Willy Walker: So just one final thing on that, which was yesterday, the numbers came out on retail sales, and they were down 1.1% in December. That's another one of those deflationary data points up. But that's off of a peak of $586 billion of retail sales in November, which was an all-time high. So, the retail sector is still looking very strong.

Dr. Peter Linneman: By the way, Willy one thing, it's not a coincidence, the -1% annualized is essentially what prices were down. So, units stayed at record high is the simple way to think about it. Units stayed at record high. Prices fell like 1% or so on an annualized basis. That's where we're at. Record high, flat prices have fallen.

Willy Walker: And so, in the retail space, you like Denver, Phoenix, and Washington, D.C., you don't really like the Midwest, Cincinnati, Chicago, and Saint Louis.

Dr. Peter Linneman: For static demand growth you just don't get. But think of it this way. We're not adding any product to speak of. The only thing being built in retail is, adding onto a center because you have a tenant. There's not much spec development. It's all build to suit, if you will, almost. And so, it's a sector where you've got reasonable supply and therefore it's all about demand. You're not going to get quote, “over new supply.” It's all about how fast demand grows.

Willy Walker: And so, I thought the development dollar number that you have in The Linneman Letter is fascinating. So, I said previously, $73 billion going towards office, relatively speaking only $38 billion going towards new retail. And the one that really caught my attention, which is another sector that you like, is hospitality. Hospitality right now with projects underway only has $18 billion of capital. So, it's literally a quarter of the money is teed up going into hospitality right now that's going into office and half the money going into retail where retail and hospitality both are showing extremely good fundamentals right now and rising out of the pandemic, whereas office seems to be going the other way.

Talk for a moment about hospitality. ADRs are up significantly in October versus the previous year. The occupancy you predicted accurately in 2021 that it would take us until the summer of 2023 to get back to occupancy in hospitality where we were pre-pandemic. And you’re right on track to be right back to occupancy numbers in hospitality of where they were pre-pandemic by mid this year. Talk for a moment about what you like in hospitality.

Dr. Peter Linneman: Don't overstate the accuracy of my prediction. Okay, so first of all the construction numbers for hotel are misleadingly high. I mean, they’re real numbers, but it's not so much new hotels starting. It's that who put money into their hotel in 2020-2021 and early 2022. Right? Nobody. If you kept your hotel open, you just cut back CapEx. You did minimal just to stay alive. So, a lot of that hotel money is deferred CapEx, construction expenditure. Just got to be done. So, it's even less new stuff.

Second, domestic travel, it depends on where and what, but domestic travel still appears to be about 5% below the pandemic. Now, you think about that, that's three years ago when it's pre-pandemic. So, we're five percent below domestic travel crudely where we were three years ago. If we would have talked to anybody in the business, any expert in the business three years ago, they'd have said: three years from now it'll be 5 to 7% higher in real terms, right? Couple of percent a year for three years, that's all. So, when you think about it, the pent up for domestic travel of U.S. travelers is the 5% shortfall. Plus, we probably should have been 7% higher, 6% higher. So, when I talk about how the economy can grow, why we have a rising sun, we have huge pent-up demand still for travel and tourism from our citizens.

You add to that, that China was by far the largest spender on foreign travel. They were double! In 2019, China spent twice what U.S. citizens spent on foreign travel. And of course, we were one of the primary destinations. As you know, it went to zero, effectively. There were some embassy types and so forth, but for all intents and purposes it went to zero. And I don't think it bounces back to where it was in 2019, but it is going to bounce upward this year. This year looks good. You'll get Chinese, you'll get more European, and you'll get more domestic. I feel really good about that. And on the supply side, there's not a lot of new-new supply as much as upgraded products, so I feel pretty good about that sector. You know, when you talk to guys like Chris Nassetta and such, it was an overnight success that occurred three-four hard years of work. It's another example to stay alive until.

Willy Walker: That's a case study that people ought to focus on about what Blackstone did with Hilton. So, you like San Francisco, New York, D.C., and Philly? On the hospitality side, You don't like Vegas, Phoenix, Austin, and Dallas. Dallas seems to be on pretty much every one of your don't fly zones. Right. Why are you so down on Dallas these days?

Dr. Peter Linneman: So, first of all, I'm from Philadelphia. So, do you expect me to like…

Willy Walker: And I'm from D.C., So I'm right there with you. I'm right there with you.

Dr. Peter Linneman: I mean, even if all my data showed Dallas was the greatest place in the world, they're not. All right, so let's start with that. No, on a more serious note, Dallas has always been a terrific market for developers. Because it grows, it's like year after year, decade after decade, it's been an incredibly high growth market and developers want high growth markets, they are in the business of creating product. And you say, well, but don't you want a lot of demand? And the answer is yes, you want a lot of demand.

But there's two negatives about markets, Dallas being a good example that have really high growth. One is, especially in Texas, if demand grows 3%, 4%, they always want to do a quarter to a half a percent more. And eventually that builds up. And, you know, it's a market that has higher sustained vacancy in almost everything than other places in the country, right? That's because you get 4% growth – yay! And you get four and a quarter percent supply growth and you go – hmmm. The market just got a little softer, not massively softer, but it means somebody's property became marginal. That's a better way of thinking about it. It's not that the good properties got wiped out, but somebody's at the bottom of the stack became more marginal by four and a half percent on 4% growth and somebody owned that. So that's the spirit.

The other phenomena is a bit more mathematical, which is to imagine you're in a market. I happen to have an apartment complex, you all arranged financing for it in Nowhere, Ohio. Nobody's ever going to build in this market. All right. It's Nowhere, Ohio. It's near where they frack. There's never going to be any building. There's no real growth there to speak of. But I never get new supply and I'm the only game in town. The bad news is there's not going to be big growth. The good news is I'm the only game in town. Greystar is not going to come and build there, right? It means that I'm always the best in the market. Now you go to a market where 4% gets built in a year and you do that for five years, that's 20% new product after five years. Some of that pushes the formerly good stuff down the quality spectrum. That doesn't make it obsolete. I'm not saying that, but there's this push of high growth markets for most people to bring on a kind of state-of-the-art products, some better, some worse. And so, these high growth markets have a tendency to push down. You get old before your time, whereas if you're in a slow growth market, you stay young beyond your age.

Willy Walker: Yeah, it's great. Okay, so we're at the end of our hour. I want to get a couple of predictions on 2023 from you, Peter. So, you've already stated 3% GDP growth in 2023. The Dow at its close yesterday was around 33,500; where’s the Dow at the end of the year?

Dr. Peter Linneman: I'm not a stock maven but up 7% or so, some number like that.

Willy Walker: It’s a healthy year.

Dr. Peter Linneman: That’s total return that would include dividend right that's a 7% total return.

Willy Walker: The ten-year closed yesterday I think at 342; end of the year?

Dr. Peter Linneman: Ends somewhere between, I'm not trying to be loose, but 33-38. Inflations’ down and I think that inflation could actually go negative. That's not going to push the long bond down a lot, but I think that's where you more or less end up.

Willy Walker: So long bond stays there, and we've got obviously an inverted yield curve. Does the Fed have to cut this year?

Dr. Peter Linneman: I think they do, but the Fed's going to do whatever they want like most government agencies are going to do. And really rich people in the government do whatever they want. I think it's going to be a volatile year for the Fed. They're going to mis predict themselves. I think the inflation data is not a head fake. Supply has come back.

By the way, the fallen inflation is not because of what the Fed has done. And the people say, look, why don't you give credit to the Fed? I give credit to the Fed when they flooded the market with liquidity and kept a whole lot of people from going bankrupt, etc. But the interest rate increases didn't go past 2% until well into the summer and early fall because they did it so fast. They were doing 75 bps at a time. So, all the research on all countries showed that the transmission mechanism for monetary policy (to the extent monetary policy works at all) the transmission mechanism is on the order of six months to 18 months. Well, if you raise the rate from 2% to 3%, you didn't do that until August. You're not going to see that until March, April, May, June. What happened to the inflation was that supply came back. And so, it's going to be a whipsaw year for the Fed because some of the stuff they set in motion late 2022 is going to whipsaw on them in mid-2023.

Willy Walker: So final question. The Iowa caucuses are a year and three days from today. So, a year and four days from today, on the other side of the Iowa caucuses, who's the leading Republican and who's the leading Democrat?

Dr. Peter Linneman: Well, in the most important question you didn't ask, which is who's going to win the Super Bowl? That is going to be Philly.

Willy Walker: I actually purposely didn't, I was going through my questions, and I purposely didn't put that in there because my dear Commanders are all sitting on the beach right now watching a lot of football.

Dr. Peter Linneman: But, you know, I gratuitously added it as you purposely avoided it.

Look, who do I think the candidates are? I'm not a big political maven. But it would appear to me DeSantis is going to be the leading horse after the caucus and moving forward. It doesn't mean they necessarily win the caucus, but when you see how the dust looks after the caucus, I think that. I think it's Biden and the only hesitancy on Biden is it's up to him and only he knows his health. And we've all had friends who are that age, and we all know very few of them are getting stronger. This is just an empirical observation.

Willy Walker: Other than yours and my friend Al Ratner, who from 82 to 92 only got stronger.

Dr. Peter Linneman: That's why I say and by the way, only Albert could have known his health, although I think he got something like 582 stents over that time period. And so, I think it's Biden unless he simply says this is not a job I want to do on behalf of my country, given my age and health. And you can't know his health and I can't know his health and all we as a nation can hope for is that if he does put himself forth as a nominee, he thinks of the nation in that regard, in his own health, and he makes a judgment. But as long as he says I'm willing to be, I don't know how any Democrat beats him.

Willy Walker: Yeah. Great. Well, I'm sure that as we go between now and next January, as well as into 2024, there will be plenty of political commentary in The Linneman Letter as we start to see how all of that unfolds, just because of how much of an impact the politics and who sits in the Oval Office has on all of us.

Peter, thank you so much for not only joining me for yesterday, but joining me for today. It was equally as fun on the second take as it was on the first one. And I very much look forward to seeing you soon and just appreciate the partnership and the friendship so very, very much.

Dr. Peter Linneman: Terrific. Have a great day. Bye bye.

Willy Walker: You too. Bye bye.

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