4 min read
The New York Stock Exchange was the setting for my recent chat with one of our fan-favorite guests, Dr. Peter Linneman. Most of our readers are familiar with Peter and his work, but for those who aren’t, Peter is a world-renowned economist with a keen eye for the real estate market. He is the founder of the American Land Fund, KL Realty, and Linneman Associates, where he publishes his famed Linneman Letter quarterly. During our conversation, we discussed the state of commercial real estate and the key takeaways from his latest Linneman Letter.
Before we began our conversation in earnest, I felt it was important to recognize that this is an exceedingly scary time for Israel and the Middle East. Thinking about the people impacted, both directly and indirectly, Peter and I agree that it’s important to show all the support we possibly can during this trying time.
While the Fed has been drastically increasing interest rates over the course of the past year and a half, some are still scratching their heads, puzzled by how the economy keeps growing and job numbers are staying strong.
However, Peter believes the answer is quite obvious. In reality, most of the economy is not interest rate-sensitive. 35 percent of GDP is derived from state, local, and federal governments, and another 18 percent of the GDP is made up of healthcare. Using this quick math, over half of the US economy isn’t sensitive to interest rates. At the end of the day, governments need to continue functioning and expanding the breadth of services they offer, and as for healthcare — well, people can’t exactly delay treatment for a heart attack no matter what’s happening with interest rates, can they?
You can then add in the more difficult-to-quantify things like consumer staples, home and car repairs, and cars and houses purchased in cash. All of these things are also interest rate-agnostic. When you add together all of the pieces of the economy that aren’t interest rate-sensitive, you find that these sectors make up roughly 80 percent of the economy. So, there’s no wonder that the steady increase in interest rates is doing little to slow economic growth in the US.
In Peter’s 72 years of life, he’s seen countless country-specific and worldwide problems come and go. We live in an imperfect world, so there will always be civil unrest, wars, pandemics, and the like.
However, Peter believes it’s important to remember that despite the problems the world faces, great investments have always appreciated in value. There may be hiccups and downturns in markets for short periods of time, but great investments tend to trend upward over time. This is true with every type of investment, whether it be the stock market, real estate, or some form of alternative asset.
Although there is a trillion dollars in outstanding consumer credit card debt, Peter remains relatively unconcerned with the state of the consumer. Although many believe that the average consumer’s balance sheet is a ticking time bomb waiting to burst, Peter believes quite the opposite. While there is a lot of outstanding credit card debt out there, Peter believes that this debt is being paid off during the grace period, and consumers aren’t paying interest on the money they borrow. This means that they are not using their credit cards as a source of long-term financing.
After all, consumer spending is still rather strong, credit defaults are still relatively low, the job market is still very strong, and companies are still hiring. When you couple this with the fact that most consumers have a very low-interest rate, 30-year fixed rate mortgage on their home, consumers are actually in an incredibly powerful economic position.
Given the precarious state of the office market, many are looking to convert existing office buildings into multifamily housing. However, it’s a rather risky process that requires extensive experience in real estate, as well as the proper financing, because these conversions aren’t cheap. Walker & Dunlop has helped finance a few of these deals, and Peter is actually working on a conversion himself.
Believe it or not, the most difficult part is not actually the conversion. Although adding all the utilities necessary to facilitate a proper conversion is difficult, finding a building with the right occupancy is even more difficult. That’s because most office buildings are not 100 percent vacant. Oftentimes, they are at 25, 35 and sometimes even 50 percent occupancy. Many of the tenants have long-term leases locked in, which makes them incredibly expensive to buy out. It is simply not economically feasible to convert most buildings with mid-level occupancy rates and long-term tenants.
To watch the full interview with Peter and see our list of upcoming guests, be sure to check out the Walker Webcast.
Willy Walker: This is a very challenging time in Israel and in the Middle East, and we're going to dive into that in a moment. But before we dove in here, I just wanted to say, thinking about those people, and obviously showing all the support we possibly can to those people impacted both directly and indirectly by the violence going on in Israel right now.
You start this quarterly Linneman Letter, Peter, with pointing out that only about 20% of the US economy is really impacted by these rate hikes that the Fed has been under. And you sort of say, hey, Federal Reserve, what surprises you that when you do something that only impacts 20% of the economy, that other things continue to function normally?
Peter Linneman: For years, the Keynesian models never worked, and yet they're constantly surprised it doesn't work. The 80% is not a precise number. But let me just give you a sense of what it is. State, local, and federal government, about 35% of GDP. Do you think they're not hiring people because the short-term interest rate is up? In fact, if you look at their hiring since the interest rates began rising, (I'm not saying they shouldn't have hired people) they're way up like 400,000-500,000 people hired since rates started going up. Nobody's surprised when I tell you that, right? They're not saying they're going with the rates up. Then let's go to 18% of the economy is health care, roughly. And if I had a heart attack right now, I'm not going to look up and say, don't take me because the rates are too high. It's not going to happen. Or there wasn't a young woman who was two months pregnant when the rates started to rise who said, Oh, honey, we're going to have to keep it in until 2005 when the rates come down. It's not the nature of health care. So, health care is kind of immune. Well, just those two, you don't even have to get more sophisticated – you're at 53% of the economy.
Then you say, okay, 25% of the people who buy cars, buy it all cash. Toilet paper, you know, etc. There's a whole bunch of things and you end up (I'm not trying to be too precise) about 20%. Some manufacturing all autos, namely the people who are buying it with debt, but some manufacturing not all and all of the capital is not short term. You have some real estate, not all. Any of you who took out a Freddie or Fannie ten-year, you know that Walker & Dunlop arranged for you…
Willy Walker: Thank you for the plug. I appreciate that.
Dr. Peter Linneman: Yeah. I mean, you know, you took it out in 2021 and you haven't bought anything since. You're not interest rate sensitive, right?
Willy Walker: That was one of the interesting things this morning on Squawk they had this panel talking about inflationary pressures. This woman came on and she's like, there's inflation everywhere and it's in this and it's in that, and it's in housing. And I was like, it's not in housing because 80% of American mortgage holders are locked in an interest rate under 5% in 2020, 2021 and 2022. It's like their cost is not going up. The cost of buying a house is going up, but their cost due to inflationary pressure is not.
Dr. Peter Linneman: And that is going up because of a fundamental shortage of housing. You know that we have got a three and a half percent shortfall of production over the last 15 years or so. That's not going to go away in a hurry. So you go, okay, people who locked it, lots of corporations locked in long term debt – they're not facing, but companies who use a short-term line of credit, they're affected. I'm not saying none. On the other hand, I don't know about your company. My little company doesn't have a line of credit. We don't have a bank line, so we're not affected by it. A lot of consulting firms and such aren't affected. So, I'm just giving you little examples.
Developments are affected because you're on short term rates. If you look at development as a percent of the economy however, it's pretty small. So said, even if you cut development, which we finally are seeing happen, you and I talked about the multifamily numbers. We just couldn't figure out how they were possibly as high as they were reporting. And I think they're down. I think you’ll agree it may be 220-250,000 on a run rate right now. Okay. So fine. You go from what we were like 600,000, but it was only there for a few months at 600,000 and then it came down to 550,000. So fine, let's say we cut multifamily from 600,000, 200,000. It's a tiny part of the economy. You're not going to slow the economy on that, right? Forget you took a macroeconomics bullshit class, right?
Willy Walker: Not from you.
Dr. Peter Linneman: Not from me. I mean, I have some students here, former students. But just think we were talking before that oftentimes the answer is so obvious that you don't think about it. How could it possibly have a big effect? And then you add to it travel and tourism is still not quite back to 2019 levels. Huge pent up. Autos...
Willy Walker: Although you do point out in the Linneman Letter that Vegas is back, and conventions are back. You pointed out in the depths of the pandemic, you said people will come back to conventions, they'll come back to Vegas. And there were a lot of people who said give up on conventions and give up on Vegas.
Dr. Peter Linneman: No chance. I mean, we like our vices. And I mean, conventions for real when you think about it, interacting is useful. Everybody sitting here could have been sitting in the closet today instead of coming and seeing Willy. By the way, a lot of people now think my name is Willy Peter because he always mentions himself first.
Willy Walker: I was actually talking to your former partner in the Linneman Letter this morning, and he said that I use so much of your data on CNBC this morning that I had to give you some props on national television.
Dr. Peter Linneman: There we go. There we go. We’ll have a banner behind you.
Willy Walker: I'm going to try and squeeze you in.
So, but Peter, you called for a couple of things that I think you got really right. And then one of them that you didn't get right. I want to understand why you didn't get it right. At the beginning of the year when 60% of economists were talking about a recession in 2023, you said no recession.
Dr. Peter Linneman: Not a chance.
Willy Walker: You just came out with your updated 2023 GDP growth number at 2.3%.
Dr. Peter Linneman: Right.
Willy Walker: Okay. And you have pretty high CPI prints from here to the end of the year. High fours, low fives. Why did you in March, when we were together, think that you'd be able to have two plus percent GDP growth, CPI continuing to print in the high fives and low fours and yet the Fed would cut.
Dr. Peter Linneman: Okay, so the economy part is easy, the GDP part. We still are below trend. You go back to the pre-pandemic trend; we're still having caught up. We're catching, but we haven't caught up. That's all this pent up. We want to do stuff. And you can name a lot of this health care that we forestall during the Covid. A lot of it is travel and tourism. It's not only, a lot of it is auto.
So, there are things that are pent up that's going to power us through. That's why I don't think. Now the inflation is very nuanced, and we talked about this: is it year over year you're talking about, or as we are happening? And the numbers are very confusing. So, I keep saying inflation is massively lower than people are being told and I'm looking at the same data.
So, the personal consumption expenditure price index, which historically the Fed has said is the preferred measure. Greenspan used to swear by it. And it was last month annualized on the core 1.3%. 1.3%. So that is to say as we sit here, that's what it was. I don't care what year over year. You know, it's like saying, well, I wasn't driving my car very fast a year ago, I don't care. You're driving like a bat out of hell now, or I don't care if you were speeding a year ago. You're sitting in the middle of the expressway, not moving now. I'm looking at the moment. That's all I'm doing.
If you look at CPI, you will basically get the same picture, except it tends to run 2 to 3 and a half percent on CPI if you annualize. Now, they'll say, well, yes, last month the personal consumption expenditure index was 4% annualized, if you include energy. Again, forget you went to any school. Just why is oil up? Does it have anything to do? Did the increase in oil prices in the last month or two have anything to do with the Fed? No. What it did have to do with – Saudi Arabia reduced production.
And what happened to the price? Now, is anything the Fed going to do, going to have an impact on that? Maybe something the White House does, jawboning with Saudi Arabia or whatever. And by the way, we had a little back and forth, which is the U.S. has reduced its oil production because they were reacting to the drop in oil prices that occurred. What's happened to the rest of the world other than Saudi Arabia since then and where it all-time record oil production, because Guyana and so forth and so on are bringing on production because it makes sense.
Willy Walker: But the thing that I didn't understand and that you and I were going back and forth on was this, you very clearly state in the letter 20 million barrels per day consumption in the United States, pre-Covid. Covid hits, we dropped down to 14.5 million barrels a day of consumption in the depths of the pandemic.
Dr. Peter Linneman: April–May 2020.
Willy Walker: And then we revert back for 2022 to 20.2 million barrels a day. 2023, we're at 17 million barrels a day. I don't get the 3 million barrels a day less consumption in an economy that's growing at 2.4% GDP growth. I mean, Tesla, as much as Elon Musk wants to take over the world, we don't have Teslas on every corner. What is causing us to still use three million barrels less a day year to date, 2023?
Dr. Peter Linneman: Clearly some of its efficiency. Now that's a 15% efficiency improvement year. That's not true. Everybody would agree. Some of it is that inventories have been built up and are run down. And the way they measure.
Willy Walker: Does the restocking of the strategic oil reserve count in like 20 million barrels?
Dr. Peter Linneman: That would have been part of that. I don't know how much they did restock to be honest, but it would. So, I mean, there's a lot of things happening. But it's clear that we're consuming energy. It's clear we're on a long-term trend. It's related to this technology issue being a wonderful salvation for a lot of our life. I was reading the other day that the Phoenix metropolitan area, which is I guess by population now the fifth largest in the United States, by people.
Willy Walker: Mariposa County has been the fifth fastest, largest county in the country for five years straight.
Dr. Peter Linneman: So, you know, fastest growing. I think there's a couple of places where an apartment hasn't been built…
Willy Walker: They didn't put the apartment; they're putting the chip plant Because chip plants don't use water.
Dr. Peter Linneman: Here's a question: How much more water is used than in 1950 in Phoenix?
Willy Walker: Zero because 70% of the water in Arizona is used for agriculture.
Dr. Peter Linneman: Yeah. The recycling of water and other technologies, is that amazing? The population is like 18-fold, or some crazy number fold and they use the same amount of water and that's a miracle, if you think about it. That happened slowly over 72 or 73 years.
That's a bit of what's happening with oil. Although a lot of these numbers are hard to measure. People forget, one of the things, we've talked about this. My view of the economy is not equations. I mean, I sometimes use equations. And so, my view is not an equation. My view of the economy is to go to an art museum and see a Seurat painting. And Seurat was a pointillist, just little dots. And as you get close, you see nothing except little dots. And it could be an impressionist. The same point. My view is that I see this big Seurat painting. And if I get too close, I don't understand anything, even though I know that that dot was created by a set of chemicals and so forth and so on. But the point is, you have to step away from all that and just try to get the fullness of the picture. And I don't always get the fullness of the picture.
Willy Walker: You get it pretty darn well.
Dr. Peter Linneman: But that's the game. And people get hung up in the chemical compounds of what makes that dot different from the other dot rather than the image of it all. And the image is constantly changing. That's different than a Seurat painting, right at the image is constantly, constantly changing. So, one of the things people fail to understand is the data is not so great and is not so constant.
Surveys, and you go like, how many of you have taken a survey that the federal government has administered in the last six months? Anybody? And yet real people do it, but they have a harder and harder time getting people to take them. Because we're also sick and tired of the phone calls that come in. We aren't answering their calls so that even if you were willing to. So, the data gets more blurred, if you will, not the fault of the government. And by the way, you know, I'm more than happy to blame the government for everything.
Willy Walker: I know. I realize that.
Dr. Peter Linneman: I'm joking. You have to have an understanding that these things are going on. The CPI data. Housing is terribly measured. And that's why I come down it's much lower.
Willy Walker: So, you talked about Phoenix as being one of the high growth cities in the country. In this Linneman Report, there are a number of cities that I put out there as cities that show the growth in payrolls from pandemic forward. So, every major economy tracked by the Linneman Letter has gotten to pre-pandemic employment levels.
Dr. Peter Linneman: Yeah, basically there may be one or two, but I think I track 48 or 51.
Willy Walker: New York, for instance, is 40,000 jobs below pre-pandemic. Just as an aside. But so, as you look through that, there are about six, no, it's a little bit more than that. It's like eight economies that have grown by over 100,000 jobs. And one of them is the out, out, out, out outlier and that is Dallas, Texas, which has grown by 427,000 jobs. Payroll jobs in Dallas, Texas, since their pre-pandemic print. And there's a lot of supply in Dallas. And we can talk about how that all plays into the housing market and all that.
But one of the things back to your equations that I thought was so interesting was that you have a number of indices in the letter that talk about if you get 1% growth in employment, you then are going to get a tightening in vacancy rates in office and retail and hospitality, RevPAR will go up, etc., etc. and you track this over time.
Dr. Peter Linneman: Right.
Willy Walker: But in an economy of Dallas, Texas, which has added 427,000 jobs, that would equate to a tightening in office vacancy levels by about four and a half percent on your equation all markets over a long period of time.
Dr. Peter Linneman: I assume your math is right.
Willy Walker: About four and a half percent.
Dr. Peter Linneman: I agree.
Willy Walker: Office vacancy in Dallas, Texas, today, 18.8%.
Dr. Peter Linneman: So that is the problem that encapsulates that little example – encapsulates the problem faced by the office market, which is historically, whether it's my numbers, your numbers, whatever, there was always a strong positive correlation between net job growth and net space absorption.
It differed depending on the city, differed in the suburbs, it differed over time how much space? There always was a clear positive correlation. And what we've had for the last, what, three and a half years is a modest negative correlation. Now you can sit here, and I can sit here and say, Ah, it will revert. I believe it reverts. And in fact, one of the challenges of reading my stuff in the Linneman Letter on office is implicit, not explicit because I believe it reverts back to a positive relationship. But do I know that? No.
By the way, it didn't disappear for apartments. It didn't disappear for industrial; it didn't disappear for hotels. It may have tweaked, but it didn't disappear. Office has disappeared. That means the risk is really gone. So, in the past, you could look at office and say, In tough times, we've had tough times in office. Right? And you could look at it and you could tell yourself, but as long as I believe if jobs come back. That's what I'm really betting on. Don't bet against the US economy as long as I'm going to believe in that, it will come back. And you have a sense.
Now let's play it out. Let's assume it never comes back, that relationship. That makes office just riskier than normal. And by the way, if you're a lender you're not going to step up to something that you can't quantify at all. Or at least in traditional metrics you can't quantify. So, if you think it's off putting for the equity, it's doubly off putting for the lender because the best that happens to the lenders, you pay them back. That's the bet. So that's a real challenge.
Willy Walker: You also make a point that allocation of capital will shift now to multi and industrial and away from office. So in other words, someone sitting there with a normal allocation, we want to put capital into the United States, your auditor or whomever that you're going to underweight, and that's only going to push more capital flows, which then you're going to have cap grade compression on industrial and multi and you're going to have that cap rate expansion on those that aren't getting the capital. Correct?
Dr. Peter Linneman: And the reason being that if you go back to 73, 74, 75, 80 through 82 to 90-93, Russian ruble, the dot.com collapse, great financial crisis, if you go back to those, the financial markets were in trouble and the property market was in trouble, and that was true across the board. It's true for industrials, true for retail. It was true for apartments. It might be more true for one submarket then, but it was true across the board. So, if you wanted to quote, bet on I'm a believer that capital markets come back and normalize, which has always been a good bet. The only question is when and if you want to bet on, yep, the economy's going to do good. You could spread your bet and include offices in that. And lots of people did include offices in that. Now, the capital markets are staggering across the board. But apartments supply demand, you can find some submarkets where it's not great, but rent and occupancy in most apartment markets are pretty good. And yes, it's not rising as fast as it was 18 months ago, but pretty good.
Willy Walker: Well, you point out in the Letter that nominal rents still might be going up in some markets, but real rents are not?
Dr. Peter Linneman: Yeah, and I always thought that would be the adjustment that nominal would go up, real would fall slightly because of the difference. That by the margin, which is important for coverage because if nominal goes down, your coverage goes down. If nominal go up, real go down. It's not great but. Apartments rent and occupancy, decent. Industrial rent and occupancy are pretty good. Good retail rent and occupancy pretty good. By the way, would you like it better if you're an owner? Of course. But rent and occupancy are pretty good. Hotels rent and occupancy pretty good with a lot of upside.
Willy Walker: RevPAR is almost back. 6% below the trajectory if we'd never had a pandemic.
Dr. Peter Linneman: That’s right. But six percent's a lot of upside. And then you go office - rent and occupancy, nyeee. Absorption – nyeee. and I don't know if there's still a positive correlation. I believe there is, but I don't know there is. So why would I? The problem is, if I'm going to make a bet on capital markets recovering, it's a simpler bet to go into those other sectors.
And if I'm going to make a bet that the economy grows, it's just a simpler, not saying better bet, just a simpler bet. And I don't need the brain damage, just kind of what I think capital markets are going to say, by the way, in the financial crisis if you wanted to make that bet, you had to make it any of those sectors. They were all in trouble.
Willy Walker: So, what ends up happening with all this office inventory, Peter, because you and I have talked about office to multi conversion. You're in the process of working on a project.
Dr. Peter Linneman: I'm working on a couple of projects.
Willy Walker: We just put a permanent loan on an office two multi conversions in L.A. where BofA had put on the conversion loan. It's 280 units. The cost basis for the developer is about $280,000 a door. We put a $55 million Fannie Mae first on that to take out the $45 million construction loan from BofA, so a $10 million cash out on a conversion – home run of a deal at a $280,000 a door basis.
Dr. Peter Linneman: Good basis. Yeah.
Willy Walker: But that's a unique deal. The developer bought the building in the 1990s for $9 million. So, you know, they had a very low basis in the actual building.
On CNBC this morning, I talked about delinquency rates during the GFC and where we are today. And the numbers are in the GFC, delinquencies got up to 8.9%, today delinquency rates are about 84 basis points. I got a phone call as I came up here from one of the major bank CEOs, and he said, Hey, I just watched on CNBC. Great. But by the way, your numbers are exactly right on Q2 2023 of where we are on delinquencies. But we got a lot of office that's coming through, this one bank has about $5 billion of office loans on their balance sheet. And he said, you know, we've taken write downs on a bunch of them. We're watching it very closely. But right now, we’ve written that down to about 50% of value.
Dr. Peter Linneman: Hmmm. So, here's the thing. They don't want it.
Willy Walker: I said, are you taking the keys? He said, no…
Dr. Peter Linneman: If I've got a good borrower, I mean, good operator, good people, good borrower. What? I'm going to foreclose on them.
Willy Walker: But at some point, somebody can't continue to pay the mortgage. They can't continue to turn on the lights.
Dr. Peter Linneman: You know, they'll kick the can down the road. And that's what's happening. But it's a very interesting thing on office, you mentioned I'm involved in a couple of conversions. There's a conversion of GNC's old headquarters, downtown Pittsburgh. Whole building except ground floor retail. Nice building. Burnham designed and so forth. One of its greatest assets for conversion was it was empty.
Willy Walker: Right.
Dr. Peter Linneman: That's not true. It has a bank and has its retail on the ground floor. You can imagine we want that anyway. It was empty. If that same building has tenants on the lease for five years, eight years or six years for 20-30% of the building, it's not economic to convert, just not.
And then you go, okay. I'm involved in another with the same partner in Cincinnati. It's Macy's old headquarters. What's its greatest asset? Yeah, it's a nice building. But it's empty. It's really empty. If that building had had 35-40% occupancy, couldn't do it. Put aside the floor plans and the windows and the plumbing all that is on top of it. So, the problem with a lot of these office buildings that he's talking about, some of them are 80% occupied and some are 70%, some 40%. And by the way, you say, yes, it's going to go down to 20%. Not if you try to buy it, those tenants are going to say, Oh, I'm planning to stay forever, and you have to buy. I mean, it's uneconomic.
What people don't realize. I've said this before, we have a lot of children in Kenya and Germany. And so, we have no children by birth. And I say that as I listen to people talking about how easy it is to convert office to residential, it reminds me of my friends who have no children talking about how perfect their children would be if only they raised them. And it's hard. It is really hard. And a lot of them don't turn out so well. But if you said to me, what's the biggest enemy of office conversion to residential? It's the occupancy between 20 and 80%. Then you start looking at floor plans and windows and plumbing and neighborhood and so forth. But basically, you can scratch almost everything. 20%-80% occupancy is not going to happen in any quick time period.
Willy Walker: As you and I transition to the consumer here. I used a sort of a thought as it relates back to the office with Peter when he and I were talking that he sort of thought was interesting, particularly given that he's a professor.
A lot of people look at CEOs like me and say, when are you going to force people back into the office? And I'm like, you know, if you get softness in a job market, CEOs will have a better ability to do that than just saying, hey, we're going to force you back in. And somebody else says, you can work flexibly, and people leave. The other thing is that flexible work schedules actually show great productivity. So, it's not like you have to do one or the other. You can work on both.
But my comment was that the next generation of professionals, those entry level people who are working, we're in a service economy. As Peter said previously, 8% of our economy is manufacturing. We're a service economy. And how do you learn service businesses being around people like him, learning from people like him. My comment to Peter was, you know, it's sort of like kids would go to see the teacher in office hours. Who are the people who went to office hours? The smartest kids in the class.
If you're not taking advantage of being in the office to learn from the people who are in this room, you as a starting professional are hurting yourself. You're not taking advantage of those office hours. And I hope that that gets out there rather than having to be sort of a cudgel from CEOs saying you've got to be back in the office, it's actually more from the next generation who says, wow, I'm not going to have the opportunity to move up.
Dr. Peter Linneman: I think that, by the way, the way you phrase that, is this the most cogent, brilliant way I've heard that issue phrased, which is it is like going to see the professor. I mean, you don't have to. But any of you who went to see a professor were better off.
Willy Walker: There’s Olivia right there, who was at Wharton with you. She used to go see you in office hours all the time here. Guess what, Olivia was one of your best students.
Dr. Peter Linneman: And one of the bright kids.
Willy Walker: Exactly. So, anyone out there who's watching this, Olivia went to Wharton and went to office hours with him and went to work at Blackstone! If you want that job, that's what you have to do.
Dr. Peter Linneman: Has her own company at this point.
Willy Walker: Yeah, it's a great path. So, let's go to the consumer for a moment, Peter, because I think one of the things that I keep hearing every meeting I'm in with a client today and I've been all over the country in the last month is Oh, yeah, but the consumer is weakening. And Steve Liesman, some of you may have seen it this morning on CNBC, Steve Liesman sat there and said, I hear all these things about the consumer going away and having all these problems. And I hate to tell you all the data would say to you there's something that might happen, but so far, you've been completely wrong. You continue to be wrong.
Peter Linneman and the letter would tell you they've been wrong up until now and they continue to be wrong. Let's talk about this for a moment because the one data point that everyone talks about is $1,000,000,000,000 of credit card debt and everyone's like, oh, credit card defaults are going to go through the roof.
And you show very clearly in the Linneman Letter this quarter that at the end of Q2 2023, credit card defaults, charge offs, were at 2.4%, which is slightly higher than during the depths of the pandemic when everyone was getting a check from the federal government. But 120 basis points below the long-term charge off average in credit cards. So, everyone's sitting there saying, ‘Oh, we've crossed $1,000,000,000,000 of credit card debt. The consumer is crashing.’ And you very clearly point out: slow down a little bit.
Dr. Peter Linneman: Well, there are two things going. Let me take the first part of the credit card debt. How many of you use your credit card to buy a whole lot of stuff? Everybody.
How many of you pay interest versus paying it off during the grace period? And I would be willing to bet that most of this audience, most of the listeners, most of the viewers pay it off during the grace period. I actually have not been able to find a number as to how much, but my gut is lots, lots and lots.
Now, that's not to say there aren't people actually paying interest on it. I'm not saying no one. So, first of all, not all that debt is really debt in the sense the clock is ticking. People are paying interest on it. I wish I could tell you how much I have searched and searched, and I can't come up with an answer. If any of you ever find it, please. I'd be very interested.
Willy Walker: Doesn’t it show up on bank earnings?
Dr. Peter Linneman: I just can't find it in full funds. I can't find it as research study. Maybe it's out there. I just haven't found it.
Willy Walker: They wouldn't have credit card interest income?
Dr. Peter Linneman: Well, yes, but what you don't know is against what true balance is the point. The point is, I am in some technical sense, but it's purely a float, right?
So that's one thing. You have to remember; a lot of that debt isn't really legally debt. But you get my point. Okay, that's one. The second thing let's go to the consumer. Forget everything you know and let me describe the consumer. Everybody who wants a job, has a job. Anybody who's thinking about getting a job, can get a job, it may not be the job of their dreams, but that's never been true, especially for young people. Your first job was not the job of your dreams unless you had a lot of nightmares. But it's not the job of your dreams. But anybody who wants a job has it. Anybody who wants to get a job knows there's a job out there for them. Their real wealth, real household wealth in 12% in real terms after inflation up 12% versus pre-pandemic.
Willy Walker: A staggering thing is that in Q4 of last year, it was up 7.5%. In Q1 of this year it was up 10.5%. And in Q2, it's up 12.6%. It keeps on growing.
Dr. Peter Linneman: And the point is it's got balances.
Willy Walker: What's driving that?
Dr. Peter Linneman: Well, homes because we don't have enough homes. Right. And that helps renting and single-family renting. It helps because they have to wait longer to get a down payment as home prices outstrip inflation. But you've got a job. Your wealth is up. Your income has outstripped inflation since 2019. So, you've got a higher real income. What else? You got huge real cash versus 2019 down from a peak.
Willy Walker: $4.3 trillion of real cash.
Dr. Peter Linneman: Cash like cash, cash. You mentioned the people who've locked in their mortgages at low interest rates. Not everybody. But what's there to be upset about? Now, you say geopolitical, of course.
This goes back to something I think we talked about probably two years ago on my 70th birthday. I think I had a Linneman Letter that said, gee, I'm 70. And if you look at all the problems that are out there and I made this list, you may recall all the headline problems that are out there. I said, you know, in my entire 70 years, you could have made a list every year of all the problems. And yet GDP grows, wealth grows, stock market goes up. Does it go up every day? No. And we always have a list. We always have a list. On your comments about Israel, I could not improve on or add to. But this is not the first time the Middle East has had problems. This is not the first time you can go across any problem in the world. It may not have been occurring then, it may not have been occurring to you, but it was occurring.
So, I have effectively a daughter in Germany, and we talk in the morning, and she's very concerned about the world situation. And I say, sweetheart, you understand what was happening in 1943 where you live? Do you have any sense of what was going on then? And I say, my father in 1943 is wadeing ashore in the South Pacific. Not for fun, not good. And by the way, you can go to China, and you go back 25 years ago, they had no economy. They had no economy. Is China's economy got challenges? Yep. It had no economy prior to Deng Xiaoping. I was there in ‘86. They had nothing. India, do they have a huge set of problems? Yeah, they have no economy 30 years ago. Now they have an economy with a lot of problems. They just had a lot of problems 30 years ago and no economy. I'm not trying to be glib, by the way, the education system is probably getting worse. But that's only since you guys have graduated.
Willy Walker: Exactly. But one of the things, as you run through that picture of the U.S. consumer, Peter, and you just ticked off all of them and it's super strong. The one thing that is down from pre-pandemic to today is consumer confidence, it is down by about 20 points. This is the Conference Board Consumer Confidence Index that you put in the Linneman Letter. Right. And I have to say, I sat there, and I looked at all the data you put forth, and I say to myself, wow, how is it that the consumer has less confidence today than they did in 2019, given the numbers you put in there?
Dr. Peter Linneman: Okay. You want me to give a glib answer? My glib answer is, a year from now, we're probably going to be electing one or the other who are basically 80 years old.
Willy Walker: My mind went back to the fact that in 2019 we had cut taxes. We were spending almost 5% of GDP in deficit spending. So, it's a free lunch for everybody. And President Trump gave everyone a sense, whether you liked him or hated him, that we were kicking ass.
Dr. Peter Linneman: A lot of things happened. I think in the arc of history, we're probably in small doldrums right now. I mean, there are big doldrums like World War II. That's more in the doldrums. And then there are small doldrums. And then right after the wall fell, that was yeah, whatever. The opposite of a doldrums is. So, the arc of history has those.
Willy Walker: You mentioned the wall. Let me go to 9/11 because many of my Jewish friends over the last couple of days have compared what happened over the weekend in Israel to 9/11 and the terrorist attack. If you think about the impact on the U.S. economy in the way we changed our lives post-9/11, does what happened in Israel over the weekend had the ability to have that long standing and impact?
Dr. Peter Linneman: Probably not, because those of you who spent a lot of time in Israel, they were already on a much-heightened sense versus us. They've got political issues they have to deal with. There'll be issues coming out of that.
As I talked to friends, the biggest thing that shocked me was that the intelligence service didn't have much heads up. By the way, compared to 9/11 it was 18 guys and we all said to ourselves as horrific, how did the intelligence service miss it. But it was 18 guys? This was like, well, what they believe a thousand, 2000 people went through tunnels and walls more or less simultaneously. You'd like to believe that had 9/11 had been 2000 guys, they might have picked something up. And that's disturbing, especially if you're in a hot seat and Israel is geographically.
But the consumer confidence issue is it's down, but it's still above average. Slightly, still slightly above average. There are plenty of things to be.
Willy Walker: You put it out every quarter, you have your canaries. Right now, you have nine out of 50 canaries. That's been static for the last year.
Dr. Peter Linneman: Yeah, not much has changed, except the Fed gets stupider. The reason I say they get stupider is inflation has receded. Their own index shows that supply chain issues have massively fallen. I don't know why they're married to looking at year over year.
Willy Walker: So, when do they get your message? When do they cut?
Dr. Peter Linneman: Look, I've been wrong on guessing them right, so it's almost one of these games you stop playing. But they should have cut. As you know, I was writing in December, they should have been cutting rates and they increased them twice.
By the way, if interest rates were determinant of inflation, please explain to me how for eight years through the 2010s, the short-term rate was zero and we did not have runaway inflation. Just the empiricist in you. You don't have to do any economics. The empiricist in you would say, Gee, if high inflation is supposed to be tamed by high rates, we must have had extraordinary. And by the way, it didn't. And there were a whole lot of reasons why. I mean, the point is it's nuanced.
Willy Walker: So, the forward curve says they cut in Q2 of next year. I know you're throwing darts.
Dr. Peter Linneman: I would say you're throwing darts with a blindfold on after you've been spun around. And I'm no better at that.
Willy Walker: We may need to do that on our next webcast.
Dr. Peter Linneman: So be careful out here. If you made me say, I'd say the forward curve is not terribly wrong. The problem is the forward curve is always wrong.
Willy Walker: It's been completely wrong since the beginning.
Dr. Peter Linneman: Well, and just go through history. You've got nothing better to rely on than the forward curve. But the forward curve is a terrible predictor.
I made the analogy yesterday to a client that it's like exchange rates. There's a very good theoretical model of the differential in exchange rates, and it's an arbitrage theory. And the arbitrage theory simply says, gee, I could buy this currency or that currency. And therefore, the difference should be the differential rate of inflation. If I spend three minutes with you, you would all be convinced theoretically that's right. Never predicts. Never predicts. And you go, I don't know why. That's because everything moves around so much.
And I think that's the problem with the forward curve. Everything moves around so much. There's a separate problem with the forward curve. And it happened in that period of eight and a half years. I mentioned when the rate was zero. There's an arbitrage condition on the long, and the long rate should incorporate expected inflation and so forth. But it also should arbitrage against the short rate. That is the alternative is, I just always roll the short rate forward and the arbitrage, the expected returns should be the same. Every time the Fed does something non-economic, and, in the tens, it is keeping the rate really low, it pulls down the long rate. Because you say, oh, gee, if they kept it low for a quarter or two or three. But when they start keeping it low for four years, you start going to the arbitrage condition start point.
And I think the reverse is happening right now. The arbitrage condition is driving up because you can sit here and say, I believe the long range should be three and a half to four.
Willy Walker: So, as you look to 2024, you think we get back to a normalized yield curve or do you think it stays inverted?
Dr. Peter Linneman: It all depends how stupid they are and therefore it's hard to predict. But if you put a gun to my head and you said there is a heaven and this is the determinant moment, I'd say it's going to be the long rate will be down to four-ish within 12 months. Why do I say that?
Willy Walker: And it's a normalized yield curve though, so short rates?
Dr. Peter Linneman: And the short rates come down. And the reason I go there, let's go back to the PC now. I admitted the PC is the lowest, the core PC, but it was 1.3% annualized. So, let's say it's two, two and a half. If let's say two and a half, let's just play out two and a half percent inflation. And you say how much higher should an overnight short-term rate be on safe money? And you say, I don't know, 50 basis points, you know, some numbers, not that much at risk. So that gets you to three on the short rate. And then you say, what's the long rate? Loan rates should be 150 or so, maybe 200. In the old days, before the Soviet Union collapsed, prior to Deng Xiaoping, it would be 200 to 300.
Willy Walker: Because of the amount of manufacturing in the economy?
Dr. Peter Linneman: No, it was because there wasn't as much wealth in the world. So, what happened when the wall fell? Let me just use that as the catch all, including Deng Xiaoping and India and so forth and so on. People who had no money suddenly had money. And you know what? They wanted to invest in the same things we invested in, and that included U.S. Treasuries. So, we didn't create so many more U.S. Treasuries when the wall fell, but we suddenly had people competing for those bonds that never competed for it. So, the normalized spread went from 200 to 300 basis points over inflation to more like 150 to 200 over simply because there were more people.
By the way, if you want to get your arms around what I'm saying, imagine that over the next ten years, Africa got as wealthy as China. Just imagine. By the way, when I was in China in 1986, the first time, they were much poorer than Africa today, okay? So just kind of putting it in context. What do you think would happen to Treasury yields? They go down because if you've got a prosperous operating business and a country that's got high growth, you've got your wealth there. And any money I can get here, literally here as my safe money – I'll do and that bids down the spread.
Willy Walker: So, you've got a two and a half Fed funds rate. You've got a 4% ten-year treasury. Where's oil?
Dr. Peter Linneman: Oil I think has a trend lower. We had Saudi pushed it up. One of the things we know about cartels is they are very hard to maintain. That's one of the things you probably learned useful in an economics class, which is that cartels can push up prices, but it's very hard to maintain because people cheat.
Willy Walker: We're at like 60% of our daily usage as far as manufacturing in the United States of oil. So, we're, if you will, 40% dependent on foreign oil?
Dr. Peter Linneman: Yeah, but we're not net net. It's tricky, but we're kind of net net neutral on oil. We’re positive net on natural gas. But not only do we have fracking and people say, well, fracking is being discouraged by regulations, and I'm sure that's somewhat true.
Willy Walker: We just need refining capacity.
Dr. Peter Linneman: Let's talk about Guyana. Guyana has this huge oil find and they're really poor, you think they're going to be deferred from pumping? I'm just putting a scenario; I'm not saying it will happen. Let's just say we say, no, we're not going to allow any more oil production than currently exists in the United States. We're going to net zero change. I don't think that has a big effect over the next several years, not just Guyana. I mean, there are a number of these countries, but Guyana. I mean if you're in charge of Guyana. You're pumping as fast as you can, as much as you can. It's the only way forward in life. And we are rich enough that if we want to squander, we can squander.
Willy Walker: So, two and a half percent GDP growth is already in your number. There's a pretty significant disparity between private cap rates and public cap rates, pick your asset class today. Do cap rates in the private sector need to move up to the public or do the public's move down to the private?
Dr. Peter Linneman: This is one of those areas I've changed my view over a decade. So that means whatever answer you get when you come back ten years from now, you may get a different answer, right?
Ten years ago, I would have said if I had to place my bet, I bet on the public markets. As we sit here today, I placed my bet on the private markets. The reason is that I think the financial crisis changed the desire for mark to market assets and switched it much to the benefit of companies like Blackstone and Apollo, etcetera, to a preference for non-mark to market assets or not immediately mark to market assets. I think it occurred because the financial crisis happened in the fourth quarter of a year. If you were in public mark to mark assets, you got killed, you got fired, you didn't get a bonus. But if you were in a lot of private assets, that pain was spread over time. A lot of the assets recovered in the meantime or bounced back somewhat. And yes, you didn't get as big a bonus, but you got a bonus, or you are getting fired. And I think that has filtered through and you've seen private money go way up across the board. You saw public flows, IPOs, etc., go down, not just in real estate. I think that that's fundamental. You can argue if it's good or bad, but I think it's fundamental.
So, I think that the public markets are not so tightly linked. There's probably an arbitrage condition for some, but it's an arbitrage with enough to offset I don't want mark to market pricing.
The public's problem is it probably overstates value when people really want in, and it probably understates them when people really want out. And for the normal holder, things never vacillate that much. I mean, most of us don't sell most days, much to the chagrin of the New York Stock Exchange. But most of us don't sell everything every day, right?
Most of us are saying, okay, I guess I'm a buyer or I guess I'm holding on most days and we're setting our own cap rate, if you will. The private markets just get big business spreads and the lack of transactions and what you and others quote is it had to transact cap rate. But what it doesn't include, what transactions in multi are down about 75%? Is that about right?
Willy Walker: We were off 81%.
Dr. Peter Linneman: Okay. So, what you're quoting is the cap rate for 20% of normal. You're not quoting the cap rate for 80% of normal. And 80% of normal is saying that's not the cap rate, it's just not the cap rate. I mean, it seems if you blended those two if you could go to the people who would have sold and gotten an honest answer. What do you believe the cap rate is? And you blended that in with what you sold at; it would be much lower because 80% of the observations would be lower cap rates.
Willy Walker: So, if I'm sitting here today with an asset that I am thinking about refi-ing or about selling, I hear you say a year from now I've got lower rates and I've got lower cap rates. I don't do something today. I wait until tomorrow.
Dr. Peter Linneman: Or you try to get a flex program. You try to get some kind of flexible program where you convert into. The one thing you don't want to do is mature into a funky capital market. History has proven that.
Willy Walker: So, look in that crystal ball, what's a funky capital 24-25?
Dr. Peter Linneman: Well, I mean, don't take a one year, if you get a three year. I mean, I guess I'm saying.
Willy Walker: Does the election risk in 2024 concern you?
Dr. Peter Linneman: Well, I'll be like whoever the president is at that point so old that I won't be able to be concerned by anything.
Willy Walker: Hahaha! Okay.
Dr. Peter Linneman: Does the election concern me? I've said this back what I was saying. You know, we've had good presidents, bad presidents, good Congresses, bad Congresses. We've had high taxes, low taxes, and we have whoever comes Democrat, blah, blah, blah, over my lifetime. And the one thing is we grow. We don't grow every minute, but we grow. And real estate is a long-term asset. I'm not being Pollyannaish. It's a long- term asset and I'm going to bet on that growth.
Willy Walker: Do you think that our fiscal situation in control without a Speaker of the House? And obviously we are gonna have a Speaker of the House at some point?
Dr. Peter Linneman: Well, there is an argument to be made if they're so busy fighting one another.
Willy Walker: While they’re so busy fighting each other, the Biden administration can pass a bill back stronger bill with $1.8 trillion in it. Yeah.
Dr. Peter Linneman: I get it. No, no, they weren't fighting enough.
Willy Walker: Hahaha! We just ought to shut them down.
Dr. Peter Linneman: So, I first had this quote insight when President Clinton was being impeached, and I thought, this is going to be awful. And then I realized Congress was so happy beating up on him. And defending him, they did nothing.
I'm doing this from memory. I think the total cost of that was something like $300 million defending him and attacking him. And I divide that by the population one day, it was like $18. You could go to the movies, and it was just great entertainment value is the way I view it.
Willy Walker: One thing you put in the Linneman Letter that presidential popularity, and you watch that, and you look at where Clinton went out of office. Man, oh man, was he ever popular when he called it a day?
Dr. Peter Linneman: Well, I'll give you the equivalent of that when I'm finished here today. There's going to be a big round of applause. But not because I was good - but because I'm done.
Willy Walker: Because you're done! Hahaha!
Dr. Peter Linneman: You got to sort these things out.
Willy Walker: We got a minute and a half.
Dr. Peter Linneman: The last thing I say, politics matter, but not nearly as much as we talk about them. Not nearly as much. Your fourth-grade schoolteacher matters, but not nearly as much.
Willy Walker: 35% of our GDP is spent by the government. And you're telling me that that doesn't matter?
Dr. Peter Linneman: It matters, but it doesn't change a whole lot. By the way, it changes who gets things.
Willy Walker: Boy, I tell you all of our borrowers who were watching a 482 ten-year last week come down to a 450 ten-year certainly feel like Janet Yellen has a big play in their world today.
Dr. Peter Linneman: I'll restrain myself.
Look, does the government have some effect? Absolutely.
Does the economy grow 2 to 3% in a year because of the government? No.
It might grow 20 basis points less a year, 30 basis. And then when you do that, you go oh, my God, that's $60 or $80 billion. And if the $60 or $80 billion is your $60 or $80 billion, painful. But in the big picture, ruining $60 or $80 billion is nothing. Now, by the way, if you're Zimbabwe, it's everything. We're not Zimbabwe. We have the luxury. We all had really rich friends at one point in life that could do really stupid things and still survive, that you couldn't survive. We’re that person. We're rich enough, thank God that we can survive $20, $30, $50 billion mistakes a year. Would we be better off if we didn't have those? Of course. But that's the world. That's the world.
Willy Walker: And that's going to be the final word. Peter, thank you as always, everyone here thank you for joining us today and everyone on the webcast. Thank you for dialing in. We'll see you again next week. And have a great day.
Dr. Peter Linneman: Thank you.
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