Website transcript:
Willy Walker: Thank you, Susan, and good afternoon to everyone on the East Coast and good morning to those in Western Time zones. It's an incredible joy to have my friend, an incredibly talented and insightful economist, professor, and researcher Peter Linneman on the Walker Webcast once again. The two of us have created quite the pattern on a quarterly basis of sitting down and talking about Peter's great research and what we're going to see coming ahead. And I'm grateful that Peter is once again joining me on the webcast.
Before I turn to Peter and my lengthy list of questions and I would add, we got hundreds of pre-webcast questions from people from across the country. We read them. I use them in formulating my questions. And so, to all of you who take the time to write those, thank you, they're super insightful and helpful and help guide my questions and conversations with those who I'm fortunate enough to have on to the Walker Webcast.
A couple of quick things before I turn over to Peter. We had an All Company meeting here in Denver last week for Walker & Dunlop. We brought a thousand people together. First of all, the sense of camaraderie and culture and shared culture was palpable. And I know many, many companies and organizations have held off from having gatherings over the last two years during the pandemic. I would only underscore how incredible it was to get together face to face and person to person with my colleagues at Walker & Dunlop. The second thing is that we had something of a COVID spreader event post All Company meeting. To date, I think we have 64 tested COVID cases out of a thousand people who came, and I'm assuming that there is at least 2x that of people who came down with it and didn't get tested and have a positive test. I don't say that because I'm proud of that. I would just say that COVID is becoming more and more part of our lives. And the other thing is that we only invited our vaccinated colleagues at Walker & Dunlop to the All Company. And one of the things that has been very clear post All Company meeting and what has happened with those people is that we have had no severe illness. The people who came here were all vaccinated. And while some people have felt like they've got a bad bug and been home and down and out for a couple of days, which I obviously think about them and hope that they get better soon. But we haven't had anyone who's had to seek major medical treatment because of it. And that's because we were restricted to only vaccinated people. The efficacy of the vaccine in cutting down illnesses is known and wildly, wildly studied, and conclusive. And so COVID is here to stay for a while, as we all know, and I would just encourage those who are not vaccinated yet to really think about doing so.
When I got up on stage on Thursday, my wife, as I was walking out the door, had mentioned that she'd made dinner reservations for last night for my 55th birthday and she said in passing, “halfway to 110”. And I laughed and I made that comment to my colleagues at Walker & Dunlop, and everyone in the crowd laughed and I said, you all think I'm stupid that I think I actually might live till I'm 110 years old. I raise that because Peter Linneman and Michael Roizen, who was on the Walker Webcast back in January, have a book that's coming out in September called The Great Age Reboot, and it talks about longevity, and it talks about things we can do to take care of ourselves. And one of the things that I have been thinking about since I stated that is I've never thought about living to 110 years old until I said it on Thursday, and every day subsequently, I've had a mindset of what am I doing today to keep myself either physically or mentally capable, to live up to 110 years old? And so, what I would say to Peter and to Dr. Michael Roizen is thank you for getting me in the mindset that, who knows, maybe I'll get hit by a bus tomorrow. But being mindful about that and thinking about it every day is absolutely fantastic.
Final thing on mindfulness, and then I'm going to move on. My wife also is big on mindfulness, and she encouraged me to have a word a day to focus on good things and that when you think about one word a day, that is a positive word. It can have great things happen. And so, my word on Monday was joy, and I had a lot of joy on Monday. My word yesterday was grateful, and I was grateful for friends writing to me on my birthday and other things. My word today is peace. And so given the conflict in Ukraine and lots of concerns that people have about the economy in our world, I would just wish everyone on this Webcast a peaceful, joyous, and grateful day. Finally, my guest next week is Amor Towles. If you have not read either A Gentleman in Moscow or The Lincoln Highway, I would strongly encourage it. And if you have read them, you would know that Amor Towles is to the written word today what Peter Linneman is to economic forecasting. Amor is an old friend, and I very much look forward to talking to him next week about his two fantastic novels, how he pulls it all together and how he does the writing that he so effectively does.
So, Peter, a year ago you started The Linneman Letter with a Teddy Roosevelt quote: “In any moment of decision, the best thing you can do is the right thing. The next best thing is the wrong thing, and the worst thing you can do is nothing.” Man, oh man, were you right on that with regard to putting capital to work in commercial real estate? So now you start this quarter with “do not bet against the US economy”, even GameStop?
Dr. Peter Linneman: Great point. First of all, I was going to surprise your listeners by asking you the question: What is the significance of 4567? That's good. Which, if you're not paying attention to the listeners, is April 5, 1967, was when Willy was born. So, it's 4567. You'd have gotten the answer, no one else would. So, I was going to surprise you with that. Happy birthday.
Willy Walker: Thanks, Peter. I appreciate it.
Dr. Peter Linneman: Second, I can't go without a commenting on your 110. I was just with an amazing woman, she's a staggering person who's a hundred years and a quarter. And I was with her, and she came to an event with me. You're going to make it to 110 as long as you take care of yourself. And Mike and I will talk about that later this year. So, all your listeners are going to have more. When she was born, her expected life expectancy was something like 54 years. And so, we're all going to get that.
So now don't bet against the US economy. I was having lunch about a month ago with a friend. He says, “I read your stuff, I follow you stuff and you're always pretty much optimistic about the U.S. economy, although not at every moment. But this time, we've got a divided Congress. We've got all kinds of horrible things. We've still got the pandemic; we've got the war in the Ukraine and high interest rates are going to rise. We've got inflation, blah blah blah. And therefore, I don't think the economy can make it.” I said, Bob, (if you're listening, Bob, I'm talking to you). Every year in my 71 years, you could have made a list of seven or eight really difficult things in facing the economy. And I won't go back. It's not that the list isn't real. But you know what the next word is? It’s not “therefore,” it’s “and yet.” And yet the economy basically carries forward. Yep, it could go down for a quarter or even two, even three. It prevails. Don't bet against the US economy.
So now let's assume, Willy, we had done this interview at the end of February 2020. Right. So, before the pandemic has entered our frame of reference. You would have said to me, we're going to have a pandemic. It's going to kill hundreds of thousands of Americans. It's going to make many, many more seriously ill come near to overwhelming our medical system. Lots of absenteeism. We're going to shut a third of the economy down. Truly shut it down. And another third, we're going to shut down partially. By the way, the rest of the world is going to do the same thing and we're going to have an extraordinarily divisive election and we're going to have civil unrest. And by the way, if that's not enough, we're going to have a rise in gun violence and our schools are going to be closed for the better part of a year. What would you expect to happen? And yet today, real GDP is probably 3.5% higher than it was if we'd have talked about in February 2020. And yet, in spite of that employment is only down about 1%. And yet, in spite of that industrial output is only down 1%. And yet, asset values are high. And yet, consumer balance sheets are in good shape. And yet, businesses are and so, Willy, when you think about what we just went through, it's like the trials of Job. What else can we do? And yet. So, if I had one message to take home today. And the real estate industry serves the economy, and yet doesn’t mean every day is going to be great, doesn't mean every month is going to be great? You're in the and yet business, you're in the long term. So just bear in mind when you get faint of heart about the U.S. economy, if someone told you in February 2020, everything that actually happened. Would you have guessed it would still grow by about 3.5%? That's staggering. And that really is the message of the day from my point.
Willy Walker: So, let's go to rates then because we're in a rising rate environment. And you stated in the The Linneman Letter, to quote: ``Were amused by the hair-on-fire pundits who warn of an economic meltdown when interest rates rise.” And you go on to remind us that “Even if the Fed raises rates by 150 basis points in 2022, they will remain well below pre-pandemic levels.” So that's clearly true. But isn't it the adjustment to that rate environment that causes the pain and the potential economic losses? So, to say, yeah, we were there beforehand, but we were there in a stabilized economy, we're now moving back to that, Peter in somewhat of an accelerated rate, given the raises that we're projecting ahead. So, isn't it that adjustment that's going to cause the pain and the potential economic losses rather than just sort of being copacetic about the fact that it's happening?
Dr. Peter Linneman: So, if we could have adjusted everything I just went through over the last two years, I think we can adjust to the interest rate going up a little on the short end. I think we can adjust to the interest rate going back on the long end. And as you note, basically a year from now, hopefully interest rates will be about where they were in 2019. We did have a conversation about price in 2019, about the interest rate environment, and it was how low interest rates are in 2019. That's where we're going to go back to. We had this extraordinary period of money being given away for free. And yes, if you were on the borrower side of money being given away for free, like a highly leveraged borrower, that was great. Like the US government, which is the biggest borrower of all. Is it surprising that the federal government has spent money like it's free when it's free for God's sake? Right? I mean, it's zero interest rate. So, higher interest rates will benefit the lender and will benefit the saver. So, when it's all said and done, it's kind of a wash, except that what it does is say to people, money isn't free, and when something that's not free is made free, we tend to overuse it. So, we're going to go back to the 2019 interest rate environment. And I would urge listeners to say not many of you were committing suicide over interest rates in 2019. Therefore, Willy, your point's right. I would tell listeners to assume that a year from now, you're back in 2019's interest rate environment. Start preparing for it – emotionally, financially. Now we could be wrong, maybe slower than that. But I don't see the 2019 interest rate environment as horrible.
Willy Walker: So, you point out in The Letter, Peter, that the only people that you see potentially having difficulty in this transformation are highly levered either borrowers or providers of capital. And I noted that last week, a poll from BTIG wrote a note pointing out that a number of the CLO issuers right now are kind of on watch list because they're getting margin calls on that. Do you see that potentially having a contagion effect on the rest of the lending community?
Dr. Peter Linneman: Could. I don't think it's big enough, and I think the Fed is quite sensitized to that after the 2008-2009 episode and the late March 2020 episode. I think they're far more sensitized to that. And if anything slows their rate's rising pace, it'll be sensitivity to that kind of environment. As you know, not only do you have to be heavily leveraged for that to matter, but you also have to be kind of cullable and you have to be mismatched, right? You've got long assets and short liabilities. So, there are some, but the typical corporation, the typical people will build our buildings, the typical people who fill our apartments and the typical owner of those aren't so sensitive to short rates. Developers a bit. Come on, developers, you have money kind of for free for two years. That was a nice gift from the government, but you can't expect that gift forever.
Willy Walker: I just want to be really clear that you are poking at our developer clients, not me. OK, so let's just make sure that you said that, not me.
So, Peter, you also referenced a Deutsche Bank research piece that focused on 13 previous Fed tightening cycles since 1955. And in it, they basically summarized that from the first-rate hike to when a recession kicks in is between three and three and a half years. Do you know what the range was on them on those 13 as it relates to was one a year in and was the other one five years in? It sounds like the average is three to three and a half, which I do think is an incredibly important time frame for all of us to keep in mind. In the sense, it's really helpful for you to point that out because it's not just three and a half years, it's the summer of 2025. I mean, there's a ton that's going to happen between now and the summer of 2025. I can barely plan the summer of 2022, much less 2025. So, is there a range there and is there a chance that it's much quicker than that?
Dr. Peter Linneman: Look, anything can happen as we found out from COVID, right? However, having said that, if history holds any lessons, we've got legs on this thing. This thing being the recovery. Look, in the normal recovery, I was saying how amazing it is we've grown 3.5% GDP, which it is. But in a normal two years, we'd have grown almost 5.5% so we've under grown. We have potential just to catch up, and then normal growth. So, I think over the next few years, that's what's going to happen. But when you go to the Deutsche Bank research, basically you're right, the early side, the early side would be 2025, the late side like 2030. Right? And so, you have to have some perspective, I think. And by the way, the things that will happen between now and then are going to have a lot more to do with profitability and viability than when that downturn comes one year or the other.
Willy Walker: So, when the pandemic set in, you coined the phrase a “butterfly recovery”, and I thought it was a fantastic way of thinking, we're going to have some stops and starts and we're going to kind of float around, but we will generally float up. But we might lose some elevation as we go. You stated in this Letter that the butterfly recovery has ended! and you're projecting real GDP growth, as you just said, of 3.5% in 2022 to 3.5% in 2023 and 2.5% in 2024. So, this means no stops and starts from here. Just bottom left, upper right.
Dr. Peter Linneman: I think more or less, yes. More or less, it goes from here now the wildcards. Why? Because we've got this pent up. We have enormous pent up still. We have enormous resources still; we certainly have capital to fund expansion. What could be the stops and starts? I think COVID hospitalizations and absentee from work are the lowest they've been since the pandemic began. OK, so that's amazing. And we're heading into the summer, so we probably get some break that way. I heard what you were saying, but by and large, the experience some people had when they were ill with COVID was similar to mine as a vaccinated person and my wife's, which was that nasty day or two but wasn't devastating. And so, absent a variant that is devastating, which obviously could change anything. Second, the biggest wildcard is price controls. The thing that worries me most that would stop the from left to right upward kind of recovery is price controls, and I'm old enough. Not many people on this are. I remember in 1971 when Nixon, a Republican, put in wage and price controls, and I remember the disaster that ensued. And yet, by the way, the US economy kind of grew over the five years, but it was a mess. It was an absolute mess because it's like fooling with Mother Nature, right? Once you do this price, there's a knock-on effect on another. That's what we found out during the shutdown. You shut down one thing, but you also shut down a lot of other things. So, the biggest risk to the recovery is not interest rates, it's not inflation, it's wage and price controls.
Willy Walker: I have to go to a quote that you put in The Letter, which I thought was fantastic where you quote Swedish economist and you point out socialist Assar Lindbeck, who asserts; “In many cases, rent control appears to be the most efficient technique presently known to destroy a city, except the bombing of it.” I highly appreciated you going in and pulling that out.
Dr. Peter Linneman: And by the way, he was an avowed socialist, he was kind of the prototype. And by the way, I think I quoted John Kenneth Galbraith, who was another kind of very left-wing socialist, famous economist. And his quote essentially says (he was in the Wage and Price Control Board, as I recall) and he says something to the effect that everybody's got a special case. Everybody's got an argument why their wage or price shouldn't be controlled, but all the others should, and he basically said, that's all we did. And the real point is you don't want to mess with the market. We found that out when we shut the market down during the pandemic, and we're still seeing knock on effects from shutting the economy down. They're going to reverberate for some time. That's what the inflation we're seeing is due to. Many other things, the lag in people coming back to work, et cetera.
Willy Walker: So, Peter, you outlined in The Letter, I think extremely eloquently, insightfully sort of the challenge the Fed has and you underscore that inflation today is not due to booming GDP. Inflation today is due to lagging supply and supply chains. And you go on to point out that they're raising rates not to slow down that growth because GDP at 3.5% is great, but it's not 5%, it's not 6%. It's not what's heated the economy. And so, you point to the fact that as they raise rates, they're actually trying to slow down an economy. At the same time the real issue is on supply chain. So, are they going to be able to sit there, raise rates to try and cool off the economy a little bit and not if you will push it over the edge into recession because the supply chain is the real issue and not a booming GDP?
Dr. Peter Linneman: Yeah, I'm an old Milton Friedman student, and I'm a big believer in “excess money can create inflation”. And people quote Milton all the time that way. But what they also fail to quote is that Milton focused on the fact that real factors matter. That was what he spent most of his time. By real factors, I'll give you the three numbers. You know them. I put them in The Linneman Letter. Over two years, real GDP, a crude measure of demand in the economy, has been up 3.5%. Industrial output, a crude measure of industrial goods capacity, is down 1% and employment, a crude measure of service sector supply, down 1%.
Now Willy, when you went to college and you never took an economics class, and I said supply is down 1%, demand's up 3.5%. What do you think happens to prices? You said they'll go up. I don't know how much. I don't know which prices. That takes more study. That's all that's happened. And what happened was demand and supply both crashed in 2020 and in 2021, demand came back faster than supply. They both came back. Demand came back faster than supply. For both technical reasons, like harbors being closed and so forth and companies going out of business. And by the way, do you really expect supply to leave demand out of a deep recession? I mean, that makes no sense. I want proven demand before I expand, right? So, we're in a situation where prices have gone up for the numbers I gave. You can do more sub. And your point is dead on. If I told you, real GDP over the last two years was up 10%, I say we can't grow that fast. That's way beyond what we can grow. That's not what we've grown. We've 3.5% and we would have normally grown almost 5.5%. It's not overheated demand. Therefore, what can the Fed do to get ships unloaded faster? What can the Fed do to get Shanghai open? What can the Fed do to get a bankrupt company that's no longer open, to open by raising interest rates? And I think the Fed realizes this, but they also live in Washington and feel extraordinary political pressure, extraordinary political pressure to do something. We're in the “do something” kind of range.
Willy Walker: Which is back to your concern about price controls.
Dr. Peter Linneman: That's my concern. They got “to do something”. And I think the Fed is going to raise rates. I actually think raising rates will be a good thing for the economy for the reasons we said. It's going to make something that's free, not be free, but it shouldn't be free and that will better allocate resources. So, I think raising interest rates for a while will actually help resource allocation, but I don't know how it does anything about inflation at this moment. Very different in less than in the 70s or some other situations. It's very different.
Two scenarios, you know how you could have gotten rid of inflation, if real GDP was down 1% versus pre-pandemic? If real GDP was down 1% and goods output was down 1% and labor was down 1%, do you think we'd have much inflation? No! Would we be better off as an economy if real GDP was 4.5% lower than it is? Of course not. So, we're better off and we're just adjusting. If you really had government policies, I'm making that up as opposed to endorsing them. You want to get more capacity back? Anybody who puts on a new line of production this year, you get to write it off in a year. Anybody who hires somebody who hasn't been employed for longer than six months, you get a $3,000 tax credit. Anybody who goes to work who hasn't worked for six months, you get a $3,000 grant, a one-time grant. That brings labor back, that would bring goods back, that would bring services back. That would push inflation down. That's the spirit of the problem.
Willy Walker: So, one final point on that and then I want to move to oil and that is that in The Letter you point out that you would never trade out 1% of GDP growth for 2% inflation. And I just think it was so well stated, and I think it's super important for people to keep in mind you would never give up that 1% of growth for normalized inflation.
Dr. Peter Linneman: Think about the size of the pie. We'd have no inflation now if the pie was 4.5% lower, namely it fit the industrial output, and it fit the service sector. We have no inflation, and we'd all have 4.5 smaller pie. How are we better off by that? Yes, inflation will be down. It's all about real activity. It's all it being the economy. Now inflation can be damaging. But right now, inflation is not damaging. Yes, it's hurting some individuals, I don't mean it that way. Right now, this is inflation that's sending up signals, big flares, saying “bring capacity here”, right here, where the price of oil is skyrocketing, for example. You know, what people forget is that two years ago, Willy, in April, two years ago, the price of oil was between zero and $20 a barrel.
Willy Walker: Our mutual friend Barry Sternlicht tried to literally buy a tanker and just put it offshore and hold on to oil. It was so cheap.
Dr. Peter Linneman: Right, exactly. So, you think about, OK, fracking, fracking it depends on which one, breaking even at something like $30 to $35 a barrel. The price is $10. Willy, how much are you pulling out of the ground, right? And everything you pull out of the ground, you're losing money because you have to ship it, store it and so forth. And by the way, you're going to do a lot of exploration when you're going to lose $20 or $30 a barrel. No. So what happened to capacity? Got shut down. What happened to planned capacity expansion? Got shut down. What happened to production? Got shut down. That's why oil is volatile. Commodities tend to be volatile. Now let's go to a world where the price is $100 a barrel and the extraction cost is $30 to $35. Guess what they're doing? And they can't do it overnight, but they're going to do more.
Willy Walker: You pointed out a year ago, you wrote extensively about the fact that government policy and the new green policy was going to create an imbalance between the carbon economy and a green economy. And you are going to have a push into renewables at a time when there was still the demand for fossil fuels – and that was going to set up an imbalance. And one of the things we're finding right now, as you accurately point out, is that the exploration and refining companies are not investing because five and 10 years from now, they don't think there's a return on going out and putting new rigs out there and going and drilling. And so, you accurately pointed out that the supply is down 10% and the demand is up 5%. (I didn't take a lot of accounting courses or economics courses as an undergrad. That's why I didn't get into Wharton, and I got into Harvard, just as an aside.) But the issue with it is Peter, you pointed that out and that the policy was going to create this supply-demand imbalance. And so, if the exploration companies aren't going to go invest because they don't see a return five or 10 years from now, what bridges that gap?
Dr. Peter Linneman: So, what bridges that gap? Remember, I was talking about $30 to $35 a barrel, let's say, the regulatory policies and all the uncertainties that make the situation better. So, suppose it pushes it up to $50 a barrel. With all those headaches and all the regulations, you've got to get your money faster. Let's say it makes it $50 a barrel instead of $30 dollars a barrel just to stay on oil. It's one hundred Willy. It's a hundred. Now, do they have as big of an incentive to do it at a 100 when the breakeven is 50? No, but they got a lot of incentive. So, you're right, and I was right about the regulatory environment went too far.
Somebody told me this morning I was talking to them, I didn't really know the person and they said, “I was listening to one of the Walker& Dunlop's last episodes and you said, don’t get cataract surgery until you need it.” And I think we were talking about environmental regulation, which is we're probably going to need, but not until we need it. I think if you recall, right? So, we rushed this stuff and cataract surgery got really expensive. And so now you say, well, woah, we don't need it that fast, right? Let's do it more slowly. We're going to get more energy. We are. And we're going to get it from traditional sources, primarily over the next five years. Yes, there'll be a push for green, but Germany's got to have electricity, right? Natural gas is going to be where it's going to come from. And a lot of that natural gas is going to come from here because it's not going to come from Russia and their system is set up to process natural gas for at least the next four or five years.
Willy Walker: So, I want to focus on one other kind of element of the macro, and then I want to dive into a little bit more kind of sector specific discussion. But labor, you have an incredible amount of data in The Letter on the labor markets and what's happening in the labor markets and real unemployment versus the Bureau of Labor Statistics numbers, et cetera. But net net, Peter, two broad questions. We're still a little bit underemployed from where we were back in 2019. You keep going back to that as a reference point. That's a good one and it's a good summary. We're still a little bit underemployed, but relatively speaking after the pandemic, we're in a fantastic place, but wages continue to increase. And I guess the easiest way to do that, the question mark that a lot of people have asked me about is the unionization at Amazon. Amazon employs 1.6 million people. Does that kind of lock in these wage increases going forward and not allow for any type of backing up on labor?
Dr. Peter Linneman: Okay, so let's go to the wage part, then the union part. The wage part is if I told you employment was the same as it was two years ago, that's pretty good. It's down 1%, but that's pretty good. Remember all those people who weren't going to come back to work, Willy, then that last summer people were saying, and I kept saying, they're going to come back to work. Of course, they're going to come back to work. And we've seen a huge surge back to work.
The problem is that we've got two years of population growth, so we would have not only had all the employment we normally had, but we would also have two years of normal employment growth. So, we're not only the 1% below where we started from, but because the population has grown, we've got a whole bench sitting there. It's like everybody who was already there, 1% fewer working and nobody who came in has a job. OK, so they're not working. That's why wages are up. You know, 3.5% real GDP growth and supply is still down 1%. Now, the demand for the labor coming back takes a little time. The union part, I think, was really dead-on point. One of the big differences between the 70s and today (I'm doing from memory) when we got the big surge of inflation, something like 35% of the economy was unionized. And the important point is not that they were unionized, they had multi-year contracts. Multi-year contracts are three or four- or five-year contracts that create a rigidity, namely, you and I are negotiating. You don't know what inflation's going to be. You don't want to look bad as the union negotiator. And so, you agree to a bump and a bump and a bump today. And I agree to a bump and a bump and a bump today. It kind of locked it in the system, right? Artificially, three and four and five years ahead got locked into the system because unions tended to be multi-year contracts rather than annual contracts because they're so difficult to negotiate. Well, we're down now to what 8.5% of the economy is unionized, most of that is in the government sector. And therefore, multi-year contracts in the private sector are rare. I mean, you don't have a lot of multiyear contracts from the top to the bottom, you don't have a lot of multi-year contracts out there. Therefore, what that means is we're going to sort it out when we get there next year. We're going to sort it out when we see what it is. Big, big, big difference in the economy. Otherwise, you could imagine multiyear contracts right now would be saying, I want a 5% bump this year. I want 5% next year. I want a 5% bump the year after that. That starts locking in a lot of stuff that's not being locked in in the same way.
Willy Walker: So, one aside on that point and then I want to go to risks. We're really lucky, I think, to have Major League Baseball having a season and there was a chance there that we weren't going to have a baseball season. And major metros like Denver, like San Diego, like Seattle, have the downtown inner core has not come back to the degree that many would like to. We're going to talk about the office in a moment. And as a result of that, the streets are still filled with people who are both homeless and in many instances are drug dependents. And it's made some of the urban cores across the country still relatively dangerous places to be. And when we had our all company meeting here in Denver last week, I got a lot of comments about the 16th Street mall. There's still quite a bit of crime and it's a sense of a lack of safety. And one of the issues is that baseball coming back this summer will bring people to the downtown core. And so, if we're talking about labor, it's a great thing that the Major League Baseball Players Association and the league came to an agreement to have a baseball season because I think that those 82 home games per city is going to have a big impact on getting revitalization, getting retail back up and going, and getting cities like Denver and San Diego and Seattle back up and going.
Dr. Peter Linneman: Well, think about where your stadium is at or where Cleveland's is at or Baltimore, even if they only get 20,000 people a night, and most of them average about 25,000 a night, 82 nights over what they play two out of every three days. So, we're over one hundred and twenty days or how the math works, right? The greatest defense is a lot of people. It's a great substitute for police in a funny way is if you have a lot of peaceable people there, there's an alcohol element that can screw that up in general. And let's face it, when you're in that big crowd in a center city, when all that activity is happening, you have a sense of peace. If you're there alone and there's nobody there, there's a sense of uh oh. And so, I think you're right. Having people coming back to the office I mean; I think it's all good.
Willy Walker: One thing before we get out of macro, and that is that your canary analysis, which I love. A year ago, it had one canary. A quarter ago, it had two canaries. And today it has four canaries. Now they're individual canaries in the sense that they're at the end of the five canary tipping chart. So, we're not at one of these things house four out of five dead canaries, and it's a real pending threat. So, let's be careful here. It's at the end of the canary line. But with that said, there are four and one of them noticeably is you have a dead canary on speculative real estate development. Where do you see that happening?
Dr. Peter Linneman: Well, it's primarily happening in the industrial, right? I mean, it doesn't take a genius to figure that out. I do believe the demand fundamentals are there. But you have to believe, right? You really have to believe that the demand fundamentals are there and the reason I believe the demand fundamentals are there for industrial is the kind of 3:1 amount of space that an online sale needs versus a store sale and increasing online sales. So, it's not 2.5% percent GDP growth generates about 4% of industrial demand, and we're not creating 4%. However, most of that industrial, you have to admit, is speculative now. It's a little odd because all multifamily and all hotels are speculative, right? I mean, you don't have tenants. Hotels, you don't see much construction going on there, with apartments, you have the best pulse to that of anybody in the industry, it's rebounding. It's coming back. But higher construction costs are kind of tamping it down a bit. Not letting it go through the roof, but I think industrial is you don't see much of the construction going on. There are projects finishing, but not new ones starting pretty much in the industrial. And it's not that I think it's unwarranted. If I thought it was unwarranted then I've killed all the canaries, right? I mean, the canary boxes are nonstatistical efforts of more money than brains. You can have a lot of brains, but you can still have more money than brains and a belief that trees grow to the sky. And you have to believe in growth to be in the real estate business, but you can get crazy in that regard. So, all I'm saying is that the trees grow in the sky, we're moving out there a little farther, particularly in industrial. Not so much the other sectors.
Willy Walker: So, you also list 23 red hot cities and then based on employment rates and growth in the cities, and then you have another 19 hot ones. Is smart capital going after those 23 red hot cities, whether it's from multi or retail or office or is the real opportunity looking at the hotter the actually still kind of cold space as it relates to opportunity to buy at any kind of a discount? And we'll talk about cap rates in a second. But as you think about the strategy today and you've got these 23 red hot metros, are you focusing on those metros to invest in or are you trying to look somewhere else?
Dr. Peter Linneman: Although one of the things I think I write about in this issue is demand growth is only half of the equation. Supply growth also matters. So, Houston's problem has rarely been a lack of demand growth, or Dallas problem has rarely been a lack of demand growth. It tends to be supply grows even faster, and it's not like San Francisco grows that fast or Los Angeles grows that fast. Look at their population growth. It doesn't grow that fast. What happens there is supply grows even slower. So, you do have to remember when you're considering investment, you have to look at both, it's the relative. What's the relative of demand growth versus supply and generally over a three-to-five-year period? Supply and demand are going to grow about the same. If you're a developer. You want to be where the demands grow, period, because you're in the business of servicing growth with your fees and creating products and so forth. If you're a hold investor, you care about supply and demand. So, the red-hot city, certainly the industrial people are looking at them pretty attractively for investing and in the red-hot cities, they're looking at them certainly from multifamily. The cold cities are starting to get a relook. So, San Francisco, New York, and Chicago are starting to get a look, but I still think certainly compared to pre-pandemic, they're still a bit out of favor.
Willy Walker: So, moving to housing, you state the Housing Affordability Index showed that only 54.2% of families earning the national median income could afford to purchase a new or used home in America this past quarter. That's off of an average over the last but 62% is the long-term average, and the height of household affordability was in 2012, right after the GFC makes perfect sense. And that peaked at 79% of the housing stock was affordable to the average national median income. So, we clearly have an affordability issue. Does that issue, Peter, give additional legs to the golden era for multifamily that you've talked about previously?
Dr. Peter Linneman: Absolutely. People are going to live somewhere. And yes, they may double up for a year or two. They're going to live somewhere. And if you handicap one of the competitors, namely single-family housing, it makes the other look more attractive. And that's multifamily. So yes, that gives it legs. That golden era that I wrote about in December 2022 for multifamily, the first 15 months have been really golden as you well know, NOIs up, capital flows are up, etc. It is still a golden era in multifamily versus when I wrote that but some of the gold has been mined. But let's face it, you've taken a fair amount of the gold cap, rates have compressed, NOIs have gone up. But multifamily still looks good on a fundamental basis, and single-family is really challenged in lots of markets. The only thing to remember about affordability is if you took out California, Oregon, Washington, Eastern New York, Boston and D.C., the nation's affordability improves a lot, improves a tremendous amount. Now you say, well, that's cheating, there's a lot of people who live there. No doubt, right? But if you're in Columbus, Ohio, affordability is pretty good. If you're in Dallas, affordability is pretty good. Maybe not as good as it's ever been, but it's still pretty good, right? So, we have to kind of understand there's a lot of variability there.
Willy Walker: I would add to those five that you just mean if you pull them out as well, you do away with most rent control in America, but that's just a little aside on those five markets that you happen to just mention. One ding potentially on multi that I just wanted to ask you about. You spent a bunch of time about student loan forgiveness, and you bring up the fact that $15 billion of student loan debt was forgiven in five rounds so far under the Biden administration. Does student loan forgiveness similar to the point you made during the pandemic, Peter, about the tragic acceleration of death of some people and that that capital, if you will, moving from one generation to the next prematurely allowed people to go and make a down payment for a single-family home and that that was one of the drivers in the growth in the single-family market during the pandemic. Is student loan forgiveness something that owners of multifamily ought to be focusing on very closely. Because that debt burden on younger residents of multifamily, if that is forgiven, allows them to go make that down payment similar to someone inheriting money, if you will, in an accelerated manner.
Dr. Peter Linneman: It certainly is worth monitoring more than the industry does. That's why I put it in The Linneman Letter, right? I would have put it in one issue and not every issue if it was a one off, kind of I'm curious about. That's why I put it in. The sentiment out there politically. Remember, most of that debt ultimately is owed to the federal government, I mean by guarantees and such and the federal government doesn't appear to want to collect it. And by the way, Willy I think of you were a House of Representatives member and I as a senator I'm not sure I'd want to go collect it, given the demographics of the voters, right? It's not a terribly popular policy, saying, let's crack down on them because those student loans are by and large guaranteed by parents or grandparents. And I'm not sure I want to take on that number of parents and grandparents. Remember, the typical loan balance is only $20-30K and to get to the one and a half trillion, that's a lot of thirty thousand. That's a lot of ten thousand and they're all voters, and I don't know if I want to go there. So yeah, I think it definitely is something and the pendulum has swung what a decade ago the notion was “by God, you're going to pay it” and the pendulum has swung to “Well don't worry about it, maybe you don't have to pay it.” That's why I put it in. Multifamily should definitely worry about it. Watch it!
Willy Walker: So, you correctly predicted that office and multi cap rates would compress in 2021. Your multi-call there were other people who made it. I think your office call may have been the lone voice in the market, saying that office cap rates are going to compress in 2021, when most buildings are 15% occupied. You're maintaining a bullish outlook on office, even though I think the stat you put in The Letter is that Castle Systems in February on 10 major metros had 36% occupancy in office. How are you still optimistic on office?
Dr. Peter Linneman: OK, two phenomena. I was just talking to a good friend in Tel Aviv two days ago, and they're back to some 5% of normal. Now, remember, normal wasn't everybody was always there, right? You were on the road some days, right. Why should Tel Aviv be different? I talked to people in London. They're back to within 20-25% of normal. Why should we be different? Now you could make an argument. Tokyo, I understand, is back to that same kind. So, one is kind of quasi empirical. I understand that's not perfect empiricism, and the other sociological. When nobody is in the office, why the hell would I go? Just to say I went? When a few are in the office, and we've all talked to people like this, right? When a few are in the office, they're not the few I necessarily have to deal with. OK. We have a sandwich. Now the psychology changes dramatically.
I think there's a social flipping point, and the flipping coin is probably around 55-60% because once they’re there I need to be there to find out what they're saying about me. I need to be there to protect my turf. I need to be there to make sure I get the plum assignments. But 5% are there, what's the benefit of being in that 5%? Not much. So, I think what you're going to see is that as the castle data gets to around 60%, it's going to speed up a lot. We'll see. But that's what I believe. And then you add to that the Ukrainian situation is a net positive for the U.S. economy, sadly, but net positive. I just think you get a lot of economic activity in all these sectors, but that's going to drive people back.
Willy Walker: So, I had in my notes at the beginning, you still actually like retail. I want to be specific here. My comment was, you like retail, not you like malls. But the news this morning of Unibail-Rodamco-Westfield getting out of their entire U.S. mall footprint is obviously big news. One of the largest mall operators in the country, I remember actually Peter back to probably 4 years ago and you were talking in our Chicago event about the fact that malls were under pressure. And Bobby Taubman stood up and talked about his malls, and you said, “Well, all you have to do is be the best mall, Bobby, and you're all good. But if you got a second-class mall too, you're in trouble.” But they're pulling out. You still like retail, given where things are moving or someone like Westfield putting up they bought Westfield for $14 billion. I don't think they're going to sell the whole portfolio for that much.
Dr. Peter Linneman: So, let's be honest, they overpaid at the time. They outbid David Simon in David Simon's backyard and it’s not exactly at that time that David was starved for money and David isn't an aggressive bidder who knows how to do deals, and the general view at the time is they overpaid. And now what we're finding out is, you know what? They overpaid. And so, Leon Bressler, will sort it through, he's a clever guy and doesn't want to spend his time battling there, would rather spend his capital in Europe.
You mentioned Bobby Talbot, who I'm very fond of, but I loved his father, and I learned a lot of real estate from his father. And I'm paraphrasing and I say this a lot. One of the first lessons I learned from Alfred Talbot, a legend as you know, was that “You cannot buy bad retail cheaply enough to make it work.” And I said, why, Al? You can buy an apartment complex cheaply enough to make it work because I can lower the rents and I'll attract tenants, I can lower, you know, et cetera, right? And Al said you cannot cut your rents low enough to affect the price of Cheerios. And if you can't affect the price of Cheerios, you cannot change spending patterns, shopping patterns. And therefore, even though you've got to cheat, you cannot affect spending patterns. You can affect spending patterns on buying an apartment cheap, cutting your rents. You will attract people. You'll have an influence unless it's in a horrible location. And the point is, I've never like since that day that was probably like 1985 or 86. I got it. I've never liked bad retail and good retail, I want. I want good assets. It'll be a constant battle, as Bobby would tell you, David will tell you, as Lisa Palmer would tell you at Regency. Constant battles. But if you got good retail, you'll win the battle. I'm very fond of Heinz as well. And we once got talking and I said, you know the problem with getting old it's like owning a sea shopping center, which is, you can exercise more and more and harder and harder, and you still get worse and worse. Right? That's the problem. So don’t go to a shopping center that no matter how hard I work, I do worse.
Willy Walker: I want to jump to the LREI and talk about just the general cap rate outlook you have because it's incredibly insightful and it's where I want to end. But one thing on that, Peter, that I think is so important for us all to keep in mind. When Blackstone threw the keys back to the CMBS investors on 1740 Broadway in New York a week before last, a lot of people said, oh, office is dead. And I think exactly to your comment about the Westfield portfolio, they just paid too much for that office building and it needs to just have a basis reset rather than the fact that the office is dead. And I think a lot of people see the headline of Blackstone walking on a big office building three blocks off of Central Park South, and they say, oh man, we've got real issues coming up, and it's really more of a basis point. They just paid too much for it. They're kicking the keys because their numbers could never work. Someone else can go by that office building and make it work.
Let me jump before you comment on that because I'm sure you have a lot of commentary on that. Let me jump to the LERI and end on this, which is that you expect it to rise 200 to 300 basis points over the next five to seven years. And therefore, you predict cap rate reductions of 45 to 65 basis points for multi, 130 to 195 basis points for office and 90 to 140 basis points for industrial.
Dr. Peter Linneman: Yeah, and that's because if you put unprecedented amounts of money in the system, which is what I'm predicting, because the Fed is pumped, so not just the Fed, all the central banks have pumped so much money in the system and it will start coming out again over the next few years. If you put unprecedented amounts of money in the system, it will push up prices. That is to say, push down cap rates. And you say, even if interest rates are higher? Yes, even if interest rates are higher. The interest rates are about a balance sheet. They're not about balance sheet. How much of the balance sheet is made up of debt and equity, by the way, for a tech firm, they have no debt, right? Some of these tech firms. The value is very high. It's not about debt. It's about value. The balance sheet is a separate discussion, and yes, if interest rates go up and cap rates come down. Oh my God, you can't borrow quite as much and have the same coverage.
But you know, I was in Egypt recently looking at the back, there's nothing on all those walls that I could find in hieroglyphics that says real estate guys have a right to borrow 70% and have 1.5 interest coverage, it wasn't there on any of these temples. Right? You may have to go down to1.62% and you may have to have a reduced LTV and that's how markets work.
But if I told you $2 Trillion additional dollars want to be in multifamily within the next three years, what do you think is going to happen to the price of multifamily? You don't need to know anything else, right? The weight of $2 Trillion trying to find it, now, it's not going to be that much, but it's going to drive cap rates down. And if I told you a trillion dollars is going to try to get out of multifamily over the next couple of years, what would happen to cap rates? They’ll skyrocket. There's no money. It's primarily about money, and we cover this with a lot of care or at least as much care as I can muster in the last several issues of The Linneman Letter and some serious research, but also some anecdotes the way I was just doing.
Willy Walker: On time, insightful, amazing data in The Letter. Anybody who hasn’t read it ought to get it. We'll do this again next quarter, Peter. Thank you. I look forward to seeing you soon.
Everybody have a wonderful, peaceful day and let's hope for peace in Europe and in Ukraine. Our thoughts and prayers are out to those people. And again, Peter, deeply thankful for the friendship and for doing this on a quarterly basis.
Dr. Peter Linneman: Thank you. Take care.
