The Most Insightful Hour in CRE with Dr. Peter Linneman, leading economist, professor emeritus, The Wharton School of Business
Willy Walker: Welcome to another Walker Webcast. It is a real pleasure to be here live in Chicago with my friend, my colleague, Peter Linneman. Thank you to everyone who took the time out of your day to join us live here today. It's a real pleasure. Many of you are both either in the real estate industry or just avid listeners of the Walker Webcast. And it's a real joy to have all of you here today.
Dr. Peter Linemann: They could be my groupies.
Willy Walker: They could be your groupies as well, Peter. I should have known that. So welcome to Peter's groupies as well. We were just having a little bit of a conversation before we went live on the webcast about the conference that you and I just attended. We were here with 75 of the largest commercial real estate owners and financiers in the country. And we spent two days talking about pretty much everything. Peter and I will discuss those discussions on a no-name basis because the law of the land in that meeting is that it's all off the record. But Peter, what did you learn over the last two days as we sat around with that august group of investors and owners?
Dr. Peter Linemann: A lot of uncertainty about what's ahead. Most of them have bought into the notion of higher rates for longer. I disagree with that, but I think that is the prevailing view.
Willy Walker: You disagree with them accepting that, or that you think that rates are going to go down?
Dr. Peter Linemann: I believe the rates come down. They don't go to zero, but I believe they should have never been at zero. I believe they come down.
Willy Walker: You know right now, you're not even as good as a broken clock.
Dr. Peter Linemann: I know.
Willy Walker: In the sense that at least a broken clock is right twice a day, your rates are coming down, and the Fed's cutting. You're not there yet.
Dr. Peter Linemann: And that's because, as I said, “I believe fundamentally in rationality.” And they just haven't been data-driven and rational even though they think they are both. They're driven by headlines, data, and an obsolete model that never works. But that was one thing I took away. I think the other thing I took away is there's a lot of money out there trying to figure out what to do. No one said it quite the way, but I've come up with a phrase of why is all the money on the sideline and some of it's being held as reserves and so forth, and it's because they're not paid to take that risk. Those who can't see that risk and these private equity funds or somebody who's running a family office or somebody who's running a bank, they're paid to take risk. You say they're paid to take certain risks. They're not paid to jump out of an airplane. That's not a risk they're paid to do. They're paid to take certain risks. And basically what they're paid to do is to do things when others are doing them. But they're not generally paid to take the risk of doing things when others aren't. And I think that was interesting. No one said it quite that way, but I took that spirit away. No one in the major financial system, the major capital, are paid to take that risk. The risk of doing something when others aren't.
Willy Walker: One thing I would say there, though, is we walked into the Schreiber Center, and you and I were talking about John Schreiber. He used to be at that meeting with us, and a number of years ago, John stood up along with Richard from colony and said, “We're in this single-family rental business.” And everyone in the room, including our dear friend Sam Zell said, “You've got to be an idiot to be in that business.” Sam's comment to everybody at that time was, “Who has ever washed a rental car, people will kill these houses. They'll be difficult.” I was sitting next to David Neithercut. He used to run EQR. I turned to Neithercut, and I said, “Would you get in that business?” He says everyone in their brothers asked me to get into it, and I have a hard enough time managing assets that have 300 units co-located. The idea that we do it over a big geography boggles my mind. No, I'd never enter that. And here we are a decade later, and boy oh boy, did Colony and Blackstone make a lot of money off of SFR.
Dr. Peter Linemann: It's a real sector, and it drives home a theme that there are niches. There were several people there who were doing niches. They're not doing the big office, the 360-unit garden apartment, whatever. There are always interesting niches that are interesting, hard to place lots of money in the niches, but you can do it. The single-family rentals are a good example, though it was a niche. There were a lot of units of single-family rental, but it was somebody owned 28 of them. And they had a pickup truck. Sam was right to be skeptical. Sam always believed you could make money owning a single-family rental if you had 19 units and you did the repairs, and you don't have to have fancy accountants and you don't have to have fancy reporting to investors. It's when you try to scale, you have to have fancy accountants, and you have to hire MBAs, for lack of a better phrase. And that overhead is hard. And could it be supported? That's what those guys did well. They got over that hump and did it well. And that took a real belief. And by the way, they suffered trying to get to that point. It wasn't all fun and games to get to that point of scale.
Willy Walker: Talk about some of those specialty products for a second, though, because we talked about manufactured housing. We talked about cold storage. We talked about student housing. I thought one of the funnier comments that was made was, what happens to student housing that goes bad? And the person who made the comment said they turned into section eight housing.
Dr. Peter Linemann: Who else wants to live near students? People who have no choice. That's not quite true because there's senior housing on a number of these campuses that's quite nice. But you get the spirit of; I had never quite thought of it the way it was expressed. It was very interesting. Apparently, there are several projects that have failed. There's a lot of supply coming online in student housing. I laughed. Student housing has been a very good sector over the last whatever some of you may do it. And I've paid for kids to live in these places. So it exists on two lies. The first lie is the little 20-year-old female comes to Grandpa and says, “I don't feel safe in the dorms, and they aren't safe. And for an extra thousand a month, I'll be safe.” And Grandpa says, “Well, of course.” I'm already doing $200,000 or $300,000. What's an extra $12,000 or so to have my little darling granddaughter safe?” And the other one is the 20-year-old son. You'll come in two years, and you'll say to your father, “I'm not old enough to drink, but there's a lot of people who drink in the dorms. Not me.” So it's clear it's not me. But if I get picked up in the dorm for drinking, I can get thrown out of school. But if I get picked up in private housing, by the way, I'm not going to be drinking but there could be others around me. And so the parents sit there and go, well, if they get thrown out, we give up a year's worth of tuition, the private housing is cheap.
Willy Walker: Good insurance policy. Those are the two.
Dr. Peter Linemann: Every business has got its own little pitch. But I think those of you who have paid for it have a certain familiarity with what I'm saying.
Willy Walker: We talked a bunch about office. I would say at one point in the conversation, I jumped in and said, “Can we talk about where the puck is going and not where it's been?” Back to the old Wayne Gretzky statement, but on office, it was a lot of what I viewed to be the unsolvable question, which is have office work patterns fundamentally changed in the United States or not? There was a lot of talk about the fact that the rest of the world is back in the office. The United States seems to be the outlier. There are questions about whether our overall support structure in the United States allows for it. We talked about the size of people's homes and apartments and that it's nicer to live in an apartment in Chicago than it is in Tokyo. I think there are plenty of arguments that say, “That's not actually the case.” But at the end of the day, there were two things that I thought were super interesting. One was the conversion conversation, and the other was the Kastle data. Do you want to dive into those?
Dr. Peter Linemann: Let’s take the latter first. The Kastle data is what basically you have to use unless you have a building. It tracks some buildings coming in security swipes. And it's the only data that is broad. So it gets used, and it shows about 55-60% at most. Some places as low as 50% are “back”. You then talk to people who own buildings and they'll say that they have their own security and they know who comes in the building. They show basically back-to-normal levels of occupancy on Tuesday, Wednesday, and Thursday, with some numbers like 50 to 75% on Monday. And as Barry Sternlicht once said, Friday is the national holiday. People either don't work and pretend, or they do work.
Willy Walker: But the productivity numbers would tell you that people are working.
Dr. Peter Linemann: More or less, or it tells you how little they were already working.
Willy Walker: No, I love the quipiness of your comment. But this productivity is measured as it relates to manufacturing productivity or services productivity.
Dr. Peter Linemann: Service is just hard to measure.
Willy Walker: Exactly.
Dr. Peter Linemann: I'm going to give you a real simple example of service. If I badly serve you your coffee, but I do it faster. Is that productivity? But I'm still badly servicing you. Whereas if it's a piece of rebar. There's a piece of rebar now. You have to worry about flaws and such. And so service has been notoriously hard to measure. As we become more of a service economy, it becomes more difficult to truly measure. But productivity is still pretty good.
Willy Walker: But so Kastle misses the small employers and it misses the suburban buildings that don't have Kastle systems installed.
Dr. Peter Linemann: A lot of the newer buildings. A lot of the newer buildings apparently are using a different system than Kastle. And so the newer buildings and the suburban buildings probably have much better attendance than the run-of-the-mill. So it does seem Kastle's undercounting. The other of conversion. I think we talked about maybe three times ago. And you asked about conversion and my comment was when I listen to people, not in the business, so much like politicians talking about converting the buildings and citizens groups and so forth. Talking about how we're going to convert all these empty office buildings into apartments. And I say it reminds me of people who don't have children. Talking about how perfect their children would be if only they had children. And the point is, it's hard. You need certain depths, and you need certain lights, not only that, you need a certain cost basis. Not only that, if it's too full with too many leases they don't want to leave. You can't get to the conversions. Obviously there have been successes. It's not to say you can't succeed, but what we heard is consistent and I'm invested in several of them right now. But as with somebody who has done it a number of times before, they've probably kissed 100 frogs or 300 frogs for the one they chose. They were able to get historic tax credits and so forth and so on to reduce the basis to nothing. It's not easy. Somebody made a very interesting point. I have not done this math, but by the time you convert some of the buildings you hear about, cities are going to give subsidies to convert. For some of these buildings, some of the people have done the math, and I believe they know how to do the math because I trained some of them. Basically, say, just give the subsidy to tear the building down and build a brand new building, and you would have a better product. Now, I'm not saying that's true of everything. That's not to say every building should be torn down, but it does give some context on some of the property. I harken back to really bad shopping centers that are really badly located, and they're just going to die, and they have died, and they get torn down. And we heard about it, and I know about it.
Willy Walker: Riff on that. Go about that there.
Dr. Peter Linemann: We knew about it.
Willy Walker: We know about it. But the issue with it is that the conversation that we had on retail and on malls happened in 2015, and 2016. When the internet was growing really fast, online sales were growing really fast. And all of a sudden, there was this big crisis around malls, and there were just too many. And in that meeting, there was a statement that said that there are 1,100 or 1,200 malls in the United States. And really, we only need about 300 of them. And here we are eight years later.
Dr. Peter Linemann: But a 900 or 1,000, and of those 300 are great, and probably another 300 are just fine, and 300 will struggle. But you have a lot of strip centers, and you have a lot of this and a lot of that. Let's face it, $6 out of every $7, not counting auto or being sold through bricks. This takes nothing away from online. so people tend to overreact. There's an argument that people are overreacting. So there's an argument people are overreacting to the office.
Willy Walker: And that's my point is that conversation was eight years ago. There's not a fundamental crisis in the mall. There are bad malls and people are sitting there either.
Dr. Peter Linemann: There's always been bad offices, or they're always going to be bad warehouses. What I'm now going to give you is an overly simplified data that I've done. This is a sharp pencil on the back of a napkin exercise. If you think about the vacancy rate of office today versus the vacancy rate in 2019, the delta, the difference is basically the pipeline of supply. So if you had a big supply pipeline, like 3% a year coming on for four years, the vacancy rose like 12 percentage points. If you were in a low-growth market and not much was being built. You may have gone from 10% vacancy to 12% vacancy because there wasn't much of a pipeline. Now, that doesn't mean it's lovely. What it does say is it's less that demand has fallen. Then demand didn't grow even though employment grew. So that's a surprise historically. It's not so much that demand shrunk. The demand didn't grow even though employment grew. And we brought on four years of supply. That doesn't take a genius to figure out that's going to be a challenge. And it doesn't take a lot of softness to make the market soft. The difference between 10% vacancy and 15% is a lot. That's the spirit of it.
If we keep adding jobs, which we have. We've added office working jobs. We just haven't had net demand from it. That's very unusual. So contrast that with the warehouse. We've added jobs and we've added more boxes being stored. Retail, we’ve added jobs and we have more stuff being bought either online or through brick. Apartments, we've got more jobs, and we have more people renting apartments. And historically, if we had more, and by the way we've added jobs and we have more travel and leisure finally occurring. Let's take them three years to get there. Office is one where you just don't see much movement in the net net demand. I still believe it happens, but I think we get three rate cuts this year, so…
Willy Walker: We're going to get into that in a second. One of the other things that came out Peter was a number of people from finance companies, whether it be the big banks, whether it be investment banks, whether it be specialty finance companies like us. The theme was capital markets are alive and well. There is capital out there. You can go find it other than for the office.
Dr. Peter Linemann: Office is pretty shut.
Willy Walker: But other than that, there's that capital out there.
Dr. Peter Linemann: I think it wasn't true a year ago. Wasn't even true, arguably six months ago. But starting around January, when it looked like they were going to stop raising rates and maybe start cutting them. Money is available not as much as you want and not at the price you want. Now, one of the things I've always found amazing, and by the way, I wrote my Real Estate Finance and Investments textbook, we just have a new edition of it out. And I was back looking at the first edition 22 years ago, and I looked at what I wrote 22 years ago about why you borrow. And the first line was, “You don't have enough money.” And then I thought you might want to try to juice returns and you might want to diversify your investments and so forth. One of the things that's interesting is that if the price of something is up a lot, you generally think of using less of it. Is that a fair statement? So if the price of donuts were to go up compared to other things, it went up a lot.
Willy Walker: The U.S. seems to be pretty elastic on the price of donuts.
Dr. Peter Linemann: We're pretty good. But you tend to consume less, maybe a lot less, maybe a little less. Interestingly, real estate people, if the price of debt goes up, I still want 65% debt. And I think if you turn to all the great books of civilizations, they believe that in the second chapter, something that says, “If you're a real estate person, you're entitled to 65% leveling.”
Willy Walker: But hold on a second.
Dr. Peter Linemann: Let me say one thing. The reason is if the interest rate is up, your NOI is whatever it is, and you want comfortable coverage, you have to
Willy Walker: De-lever.
Dr. Peter Linemann: De-lever a bit. That's just logical. And yet people don't want to do that.
Willy Walker: They don't want to do that because they've got a 65% loan that's now a 75% loan that they need to pay off to be able to move forward. You understand that.
Dr. Peter Linemann: I understand it, but there's a sense, I have a project, there's a sense of entitlement.
Willy Walker: In that group of people, many of whom are centi-millionaires or billionaires. There is a sense of entitlement to 65% debt at 4%.
Dr. Peter Linemann: Except for the interesting thing. I'm old enough to remember there are very few people, Richie, I saw you're back. Not that you're old. Remember, in the days if you had 110% leverage, it was viewed as conservative.
Willy Walker: When rates were at 18.
Dr. Peter Linemann: Yeah.
Willy Walker: Early ‘80s.
Dr. Peter Linemann: 110%.
Willy Walker: You made that point as it relates to the current Fed in the construct of economists today who are the people making opinions on that policy? None of them were trained during a period of time when we had high interest rates. You got 40 years of this now. And so you've got few people like you who really understand what it was like in the 70s.
Dr. Peter Linemann: Literally old guys who are past their due date in terms of normal retirement.
Willy Walker: That's why we listen to you, Peter.
Dr. Peter Linemann: Like I said, normal retirement. If you said, “Okay, you retire at 65,” there's no one trained in that era. They're all people who may still be active. There are plenty that are still active. I think I’m still active.
Willy Walker: So we touched on the banks for a moment, and I thought that this is a really interesting thing as it relates to where the sector is going. So two of the largest real lenders on commercial real estate stood up. Both said we're back in the market. We think we'll have loan book growth this year. But one of them, I thought very insightfully, said, “Look, the Basel III makes it so that for us to go out and do a 65% first trust loan to anyone in this room, we get a 100% risk-based capital treatment of that loan, and we need to reserve for it appropriately.” If we go out to, and he didn't use me as an example,
Dr. Peter Linemann: Nonbank bank
Willy Walker: Nonbank bank. Walker & Dunlop and we make a warehouse line to Walker & Dunlop so Walker & Dunlop can go out and originate the loan. We only have risk-based capital on that at 20%. And he basically said our whole business model going forward is going to be loans on loans, not necessarily direct lending.
Dr. Peter Linemann: Every follow that and as an incentive matter the regulations are basically saying “Lend to people who lend to the same borrowers at the same leverage, lend to the lenders rather than lend to the borrower.”
Willy Walker: And it clearly de-risked the bank because the bank is if they're going to make a 65% advance rate to me at Walker & Dunlop, and then we go out and do the actual loan, I've got the 35% equity, if you will, off of my balance sheet in front of their loan and the chance that's going to blow up. And they also, in some instances, have the collateral of Walker & Dunlop as an enterprise against that warehouse line. It's a very safe loan, but I think that it has huge ramifications to our banking system. And then also Elizabeth Warren would call it the shadow banking industry. But those Nonbank lenders who go out and raise capital from third parties and go and lend it and use leverage from the banks to go and lever it up. So the Ares and the KKRs and the Blackstones of this world will increase in their market presence, and the banks will be the lubricant to them going and lending.
Dr. Peter Linemann: And they'll become more regional-oriented in that there is a role for the other than mega banks. That mega capital and what we would call regional banks and the regional banks are the ones most squeezed right now. They're the ones that the Nonbank banks using this ultimately should be targeting. Not in the first instance, but ultimately. And you guys do, you're making loans to places people have never heard of. No, you're not just lending in New York and you're not just lending in West LA, and you're lending in real America. That's what the regional banks do if you think about it. They lend in real America. Yes, there's New York and Chicago and L.A. and so forth. So that's where that capital is going to come more and more unless the regs change.
Willy Walker: It seemed from the comments that I don't want to say the bloom is off the rose, because clearly industrial is probably the most favored asset class today still. Yet it seemed like there was a little bit of the crazy days of 1% vacancy are gone. It's normalizing it closer to 3% vacancy, which, for any other asset class, you'd sit there and say, “Oh, that would be the greatest day ever.” But on industrial, from where it's gone to where it is today, there just seems to be a little bit more of a tempered view on it. Is that what the data is telling you? Because you look at your data and essentially.
Dr. Peter Linemann: That's what the data is saying. That's what I heard. We've got a couple of warehouses we own. Look, there was a time when some of these markets had one and 2% vacancy. We know that's too low. It was wonderful, but it's too low from a real operating efficiency from the economic point of view. Great for the owner. And we had a spurt of supply. We had a little pullback in demand. Not a lot. But a spur to supply. And it's up to 3-4%. There are a couple of markets where it's higher. But those are healthy levels and not as much fun for the owner. And I think it's well summarized. It was consistent with what I've seen, which is where you used to have ten tenants walking through the space, you now have four walking through the space, and you only need one of them. Or two of them to get some bidding. It's very different from no one's walking through. And the warehouse has the one advantage of it being the shortest pipeline. So as the spurt of supply came on, it was easiest to say, “Whoops, let's hold off starting a new one for six months or a year or whatever.” So it's not perfectly shut off, but it's still a pretty solid sector. Why is it solid? The economy's still growing, and consumers are buying more stuff. We're still importing and exporting more stuff even though we hear about trade restrictions, total imports plus exports are still rising. You could argue not rising as fast as they otherwise would, but I think that's a legitimate comment. But as long as we have… Think about it this way. What fills warehouses? Boxes. I'm oversimplifying boxes. Why do they have boxes? Because we're buying stuff. And as long as we have more money, we're going to buy more stuff. Not hard to figure out, and it's hard to figure out to precision, so the economy is still growing. Demand is still there. It's not, by the way, when there will be a pause is when the economy does have a recession. But we're not going to have a recession by any normal calculation for years.
Willy Walker: Okay. Let's pause on that for a second. One of the things that I said, “I can't attribute any comment that we've been talking about to anyone else, but I can talk about what I said in the meeting.” One of the things that I said was that should former President Trump get elected with the stroke of a pen, unlike almost anything else, he can change trade policy overnight because that's an executive branch measure, they can put up trade barriers. And if you listen to the former president, what he has said, he plans on putting up unilateral tariffs around our country to basically change that trade deficit that we have today. If he does that, if he comes in and signs that is that not wildly inflationary?
Dr. Peter Linemann: It will hurt the economy and it'll hurt it in lots of ways. I don't think it'll be wildly inflationary.
Willy Walker: Let’s look at wildly inflationary.
Dr. Peter Linemann: But think about it. We put sanctions beyond belief on Russia.
Willy Walker: A year ago you see the line of trucks in Georgia trying to get through.
Dr. Peter Linemann: And it did affect it in the very short term? Had it had a notable effect, inflation and so forth and so on. But it's a big economy. It found ways around. Trucks through Georgia and so forth. The US would do the same. Let's take the extreme. Let's say nothing can ever be imported or exported other than tourists coming in and out, nothing to be ever imported. Would it have a nasty impact for six months to a year? Absolutely. What do you think would happen three years from now? Would we have as efficient production? No, but we'd figure out a way. But it's not people who are going to say we're not going to do surgery anymore because an important component came from the Philippines.
Willy Walker: But you said yourself, Peter. The stimulus we put into the system during the pandemic was purely to keep our level of consumption level. So we spent trillions of dollars to maintain that level. So when I hear you somewhat dismiss that, yea, it would have an impact for nine months or a year, and then all of a sudden it comes back. That's not the way the US government or the US people have acted through the pandemic in any way. We were not up for 9 to 12 months of that.
Dr. Peter Linemann: There may be a revolution in that.
Willy Walker: Okay. I'm just trying to double…
Dr. Peter Linemann: Economies especially as big as ours. Even Russia is far more resilient.
Willy Walker: Then we'd like to think.
Dr. Peter Linemann: That's all I'm really saying. By the way, trust me. I think one of the worst policies of the Biden administration is they mimicked the Trump administration on trade, which was a horrible policy. The Biden administration tries to reverse all these things. And here's one of the worst policies and didn't touch it. I care about economics. I stress that one. But I'm not trying to say “Oh boy I don't want tariffs.
Willy Walker: I got that, I just want people to understand the implications of that. And that's not… I hope nobody's interpreting that as a Partizan comment on my part. I'm listening to what the former president is saying. I'm thinking about what the policies he has clearly articulated would mean and try to understand what that would mean for our economy. Let me then take that to this.
You're very clear on Ukraine and on about 40 basis points of GDP growth, by your calculation, coming from oil, food, and arms. Talk for a moment about that because 40 basis points of GDP growth from Russia's invasion of Ukraine is not a minor change to the US economy.
Dr. Peter Linemann: No. Think about how we might… Put aside the recovery. Let's say we're normal now. We're not quite normal yet, but let's say we're now back to normal. And you have a little less than 1% population growth and something like 1.5% productivity growth in a normal year add them together. That's quick and dirty GDP growth. I'll call it 2.3, 2.4%. If you can get 40 basis points beyond, that's a lot. It's a whole lot, especially if you're one of the beneficiaries. So I think it was March, two years ago. I did this calculation. The Ukraine War is a horrible thing. However, the US is really good at making defense systems, and the world's demand for defense systems went way up. And that net benefits the US. And that turned out to be true. You reduce, originally cut off, and then reduce shipments of foodstuffs from one of the major calorie providers in the world. They don’t provide a lot to us but to the world. And what is the United States really good at - growing calories agricultural. And the third is oil and gas products. And Europe cut themselves off from major suppliers. And we are the largest producer of oil in the world. It's funny. People got that Saudi Arabia would benefit from Russia in terms of oil and gas. We produce more oil than Saudi Arabia. Of course, we benefit from that. You could argue about how much; about 40 basis points. And that’s where some of this extra growth is coming from. And I don’t see any of it going away in a hurry. The foodstuff has gone away, a little bit, but by the way, that could close in a heartbeat, the port. So there's good dynamics. The other thing, it's very funny, there was this narrative you and I talked about two years ago that we're on the brink of a recession. And then it was a year ago. We're on the brink of a recession. This is silly. Why? Recessions generally come from excesses that have built up in a system, whether it was the housing or you can go back historically, it was housing and autos.
Willy Walker: Commercial Real Estate in the late 80s.
Dr. Peter Linemann: Commercial real estate. It was some excess and some sort of policy. The one thing the shutdown and the pandemic did was eliminate lots of excesses. We shut down production and we went to shortages. The system was a shortage system, not an excess system. Historically, you don't get a recession until seven years. Some a little sooner, some a little later because it takes that long to get the courage to build up excesses, take commercial real estate. Nobody has the courage to really build it up, whether it's the lenders or whatever. Auto is not excessive. You can go through where you would normally see it, you don't see it. People forget, we had 22% of the labor force unemployed in April. Collecting unemployment in April of 2020. We didn't cross over where we were back to where we were in 2019 until basically two years ago. We still have a lot of runway before we get that fat and dumb. We'll get there.
Willy Walker: But so, you talk, Peter, about the fact that in the four years post-pandemic, we really have had three years of GDP growth.
Dr. Peter Linemann: Total aggregate.
Willy Walker: Aggregate. But help me understand this because you talk about real GDP growth. And that number you just used was real.
Dr. Peter Linemann: Real.
Willy Walker: 2.3 - 2.4%. Shouldn't given where inflation was, these are real numbers. Shouldn't growing your economy at 2.3% of real GDP be something that we should be jumping up and down about with that inflationary headwind you would typically think that real GDP would be significantly below that. We're on trend on a real basis with, over the last 12 and 24 months, massive inflationary pressures on that number.
Dr. Peter Linemann: It's interesting to me, that we lived through the greatest test of the American economic system in my lifetime. You could argue World War Two was. But I know I look like I was alive. I looked like I was at D-Day. No. But seriously.
Willy Walker: You think worse than the GFC.
Dr. Peter Linemann: Oh, massively worse.
Willy Walker: Really?
Dr. Peter Linemann: Massively. Here's what we lived through during the GFC.
Willy Walker: Yeah.
Dr. Peter Linemann: I'm doing it off the top of my head. Revenues in Las Vegas were off by, like 6%.
Willy Walker: I get that, but we had...
Dr. Peter Linemann: Vegas was closed.
Willy Walker: We had a global financial crisis that made it so that our own Federal Reserve did not have a playbook. This time around, there was a playbook. They're going to flood the you know what out of this system. And they went to it. You may say that the actors in 2008 were distinct from the actors in 2020 and that one team addressed the challenge.
Dr. Peter Linemann: We had no playbook at all. I'm not blaming anybody, but we had no playbook on what happens to the economy when every shopping mall in the country is forced to close. We had no playbook for what happens when Las Vegas is not allowed to have tourists.
Dr. Peter Linemann: I just think we saw… anybody who had skepticism about the true ability of the United States, which is far from perfect, by the way. You just lived through it. We had people dying. We didn't let your kids go to school. You talk about no playbook.
Willy Walker: So on that then. Isn't 2.3% GDP growth in a year with massive inflation an incredible testament A, to the economy, B, as you predict inflation coming down, doesn't that GDP number in real terms accelerate dramatically? But your projection isn't that your projection is that it sits around 2.5%.
Dr. Peter Linemann: Because we're back to normal-ish with Ukraine added on.
Willy Walker: But why isn't that inconsistent?
Dr. Peter Linemann: But let me just do one. The one that worries me most is I looked at data as I think inflation for real is notably over-measured. If I'm right, that means GDP growth has been under-measured. Real GDP growth because you've over-deflated.
Willy Walker: But go back to my core question. You have projected GDP growth over the next two years.
Dr. Peter Linemann: As you know, one of our tricks is you pretend to ask questions and I pretend I answer.
Willy Walker: No. But this is important, though, so you're inflation number, and we're going to dive into inflation in a second. But your inflation number with or without shelter is going to be around 3% with shelter it's going to be below 2% without shelter. You do real GDP growth, and you've got that having come down to that level from where it was, and on a real basis, you should be picking up hundreds of basis points.
Dr. Peter Linemann: Just to make it mechanical. I measure we're officially about 2% below trend on GDP. Let's say I believe we've overstated inflation by one percentage point. Then we're actually 1% short. That's all I'm saying. And by the way, when you get to a certain point, it gets to be rounding error. I'm not trying to change my view. I'm just saying. It may be closer to normal. That's all I'm talking about. The trend is just normal. And that's why I get 150 basis points of productivity of 70 or 80 people. And then throw in a little Ukraine effect. And you get to 2.5% or something like that.
Willy Walker: Is there an Israel effect as well, while Ukraine? Just curious. Does that have this much of an impact?
Dr. Peter Linemann: No. Their oil doesn't have as much impact.
Willy Walker: Or food.
Dr. Peter Linemann: No.
Willy Walker: Obviously, what’s that?
Dr. Peter Linemann: It's a smaller economy and it wasn't a resource provider in the same way the oil part was.
Willy Walker: The arms standpoint.
Dr. Peter Linemann: It reinforced the arms effect.
Willy Walker: Let's dive into your favorite topic. And I don't want to spend too much time on it.
Dr. Peter Linemann: It also, by the way, increased the demand for Hamas flags on campuses.
Willy Walker: You talked about that. So if you think about the numbers, you put out the day before yesterday as they relate to inflation net or subtracting out shelter, basically say they were inside of 1%. The Fed never had a 0% target. They've had a 2% target. And you're basically saying all of that inflationary pressure. The only reason that there's a three-handle on inflation today is due to housing, rent lag, and households. The owner equivalent is a wrong measure. Chairman Powell actually got your memorandum in his last press conference. He said we realize this is not a good measure of inflation, but we're not going to change midcourse.
Dr. Peter Linemann: Which is interesting. Which is, “we’re completely wrong. But for the sake of consistency, we're not going to change.” That's not heartening. You could say it's a step in the right direction, but...
Willy Walker: But that would then lead you to believe that on the next print, rather than looking at the CPI, they focus more on the PCE because the housing or shelter component of the PCE is less. Just on that, without changing anything, they can say, “Let's focus on PCE heavier than CPI,” and then all of a sudden, they get a print that is actually to your point of just read the data. They've said we're data driven. Let's hypothetically say that because the shelter we know rents are lagging. Rents are lagging. Owner equivalent is a…
Dr. Peter Linemann: …a stupid concept.
Willy Walker: But it's going to probably stay inflated. Because people think the value of their home is up even though that has zero inflationary pressure. And they get a print of 2.4 annualized.
Dr. Peter Linemann: Here's what's going to happen, PCE comes out next week I can't remember what day you may know. I think it's Friday next week or Thursday next week. PCE will come in negative month over month. And why do I say that? Because CPI came in, I’m doing it off the top of my head. I had a 0.5% headline and 0.5% annualized month over month. And it has a much higher shelter weight. So basically, when you do that math, it's going to come in slightly negative PCE month over month. And then when you annualize, it'll still be just above 2%.
Willy Walker: But they get that print. Do they cut?
Dr. Peter Linemann: The Fed has been a terrible predictor of themselves. People forget that. So when people say, “Yeah,” they're telling you they're not going to cut this year. Go back to what it was two months before the fastest increase in he said, “Don't worry. We're not in any hurry. We're not going to raise it.”
Willy Walker: But that they want to repeat the same mistake to me seems unlikely.
Dr. Peter Linemann: They're going to cut, and then they're going to see, “Oh my God. The lagging rent data ushing things down.” They may even come to understand the owner equivalent issue though I don't hold out hopes for that. Interestingly, by the way, everybody understands this owner-equivalent issue. How many of you own a home? Do any of you who own a home pay rent to anybody? A simple question. Any of you.
Willy Walker: Other than student housing operators who have your kids at college.
Dr. Peter Linemann: The answer is, of course, no. 25% of CPI and about 12% of PCE is the rent that they're saying you pay has gone up. And by the way, they're saying it's gone up by 5.7% over the last year. Now if they tell you the price of root beer is up, somebody paid it. Not everybody buys root beer. If they tell you the price of eyeglasses, not everybody but somebody. It’s an either no one has, it’s an outlet.
Willy Walker: So double-click on this, this is not the Bureau of Labor Statistics just sitting around in an office building saying, “Hey, what should we plug that number for?” It is them doing a survey where they called Peter two years ago and they said, “Mr. Linemann, we're from the Bureau of Labor Statistics. If you were to rent your house out, what would you rent it for?” And two years ago, Peter said, “I'd rent it for $4,000 a month.” They say, “Great.” They wrote down $4,000. They then called him a year later. They say, “Mr. Linemann, it's the Bureau of Labor Statistics again. How much would you rent your house for today?” And Peter sits there and he goes, “Hang on a second. My neighbor sold their house for this huge premium. And I’ve heard that the housing market is up 20 or 30%, so I ought to say it was $4,000 a year ago. It ought to be at least $4,400. And if I want to go for 20%, it’s $4,800.” And they write that down.
Dr. Peter Linemann: They also do one other thing. Ron has this mansion in Wilmette.
Willy Walker: You didn't correct me about renting your house for $4,000.
Dr. Peter Linemann: No, but the point is most owner's homes have no comp as a rental product. Some do. So even if you go looking for comps.
Willy Walker: So what we're underscoring here is how they get to it is arcane.
Willy Walker: you came up with it, by the way, with Milton Friedman in the early 1970s. So it's completely your fault that we have this.
Dr. Peter Linemann: And I was like, “Oh, but I had some.”
Willy Walker: I don't understand why the Fed doesn't call someone up who was in the creation of this thing and say, “Do you really think it's actually applicable today?”
Dr. Peter Linemann: It isn't for that purpose.
Willy Walker: But the interesting thing, some of you may have seen the op-ed that was written in the New York Times the week before last by the governor of Nevada, and it was an exceedingly well-written op-ed that said why Nevadans are going to vote for Trump. In it, the governor talked about how much housing has gone up, and he conflates inflationary pressure with going out to buy a new home. Buying a new home is purely discretionary. There are some people in this room who may need to move from Chicago to Denver, Colorado. And you are faced with, I'm selling in Chicago. I'm buying in Denver. There's a cost of living that's going to increase whatever. And you got to make the decision whether you want to take that new job or whether you want to stay in Chicago, but it's discretionary. That's not inflationary.
Dr. Peter Linemann: There's a difference. Also, there are consumer prices, and then there are asset prices like homes, gold, and stocks. You can go through the list. You don't want to conflate the two. You don't want to ignore what's happening to asset prices. But it's not a consumer price. It's an asset price. And so I do think the Fed will surprise themselves and lower fast. But come on three cuts is only 150 basis points would bring it assuming three cuts is only 75 basis points, which would bring it down to four and a half.
Willy Walker: And you're assuming that they only cut by 25.
Dr. Peter Linemann: They're cutting by 25. If they cut by that, you still have headline inflation that will be running at 3% or less. Now, if I just told you out of the blue, inflation's running less than 3%. But over two, you should have a rate of interest higher than that. But five and a half, not real. So by every metric but inflation, if you take out this crazy part that no one pays and you only leave in the items that people pay, which would be a novel idea that even the European data people have figured out.
Willy Walker: Is that one of the reasons they're cutting.
Dr. Peter Linemann: Of course, the European inflation numbers do not include this owner equivalent. They don't include it. It's not like it was etched in stone. I always loved Mel Brooks in the history of the world where he's coming down. He's got three tablets and he says, “I give you the 15.” He drops a tablet, the Ten Commandments. It's not on one of the broken tablets was you have to include your own or equivalent. You have to borrow 65% loan to value.
Willy Walker: That's the birthright of everyone in the real estate business.
Dr. Peter Linemann: When you look at inflation, absent that anomaly, you're down below 2%.
Willy Walker: Let's do this. If they cut three times this year, in our first webcast of 2025, I will call you a genius and kiss your feet. If they cut twice, I'll call you a broken clock. And if they cut once or less, I'll call you a cuckoo clock. Is that fun?
Dr. Peter Linemann: Wait, the thrice I'll agree to. But at least with two, you may not have to kiss my feet, but you at least have to say you weren't completely wrong.
Willy Walker: You're 100%. You got it. 100% I will give you that.
But let's take that into housing for a moment. Because one of the things that I'd like you to scale for people is the following. You say that we're still undersupplied in multi and that high interest rates and the cost of entry into single-family housing are going to keep people renters for longer, which from an overall macro to the asset class is very positive. But on the single-family side, what I want you to scale for people is the following, having over-delivered about two million homes pre-GFC. We got into an under-delivery cycle starting in 2009, and 2010 where basically there were no single-family homes built. And then they started to come back and triple back. And today we're about three million single-family homes undersupplied.
Dr. Peter Linemann: Ivy would agree with that.
Willy Walker: This is the Ivy Zelman.
Dr. Peter Linemann: I always say that because totally independently, I think Ken Rosen and I say that because I think they're both very good analysts. And it's not like… you may come up with half a million more.
Willy Walker: But Lennar announced earnings yesterday and had a great quarter. All the single-family home builders seem to be able to build to a demand curve if you will. That is just straight up. What will it take for us to get back into equilibrium? I think the existing homeowners are supplying around 1,000,001 a year. So with immigration and obsolescence, what does that number need to get to on an annual basis? And how long does it need to be at that higher level for us to solve this gap?
Dr. Peter Linemann: We're probably including second homes and so forth. We need about one million to 1,000,001 just to deal with the net new population, just ballpark. I'm not trying to be overly precise, but just a ballpark. By demolition and so forth. Now, let's say you're three million short of supply-demand balance nationally. You've got to produce 1,000,003 to a 1,000,004 a year, every year, for the next decade to eat through a three million shortfall. I don't think NIMBYs are going to allow that to happen.
Willy Walker: Before we jump to NIMBYs. At the height of the housing boom in ‘05 ‘06 pre-GFC, what was the peak year as it relates to single-family deliveries?
Dr. Peter Linemann: It must have been like 1,000,007.
Willy Walker: I thought 1,000,007, 1,000,008.
Dr. Peter Linemann: 1,000,008.
Willy Walker: So we've got to get back to that torrid pace if you want to accelerate it beyond a decade. But a more measured one, make sure you're producing a 1,000,004 to 1,000,005 new homes in America every single year. And right now, Toll Brothers, Lennar, and KBW ain't doing it right.
Dr. Peter Linemann: Right and I can imagine them going up 100,000 beyond that 200,000. I don't think the regulatory process will allow that pace that we had for four years in the early ‘20.
Willy Walker: And when you say regulatory, you're talking about local politics, not national policy.
Dr. Peter Linemann: Local. And it's funny, everybody thinks of Dallas for example, as being a really easy place to build. Go talk to the people who built in Dallas 20 years ago it was a lot easier. That's not to say it isn't easier than in Santa Barbara, but that's only because you can't do it at all in Santa Barbara. I just think it's hard. And by the way, ten years to eat up that excess. By the way, you know in a ten-year period, there's going to be a down cycle. You just know there'll be a downcycle. And you know what'll happen in that sector during a down cycle, which is capital will dry up for a year or two. So you're not going to be able to hit that pace even if you did, which means it's much more than a decade, at least the way I… It’s a really hard one to make up. People don't want people, I always find it funny.
I've always lived in high rises other than when I was a child. I always find it interesting when people who want to live in the city, they want to live here, and they go, but there's a building across the street, and it's going out to the urban fringe. And you say, “But there are cows out there in the pasture.” What did you expect? What's her name? Annie Leibovitz has this famous phrase, “Pretend it's a city.” That's what it is. So I don't know how we make it up easily. I just don't. And in the near term, it's not only the shortage, it's the people who are locked in. We worked on together this number together, and I'm doing it now. So basically, two-thirds of homeowners borrow, and I'm doing it off the top of my head. You may have a better memory. 90% of the homeowners who have a mortgage, it's 4% or less, roughly. So you're basically talking about 38% of the US population has locked in a mortgage at 4% or less. They're not going to be in any hurry to pay off that mortgage and move. So in addition to this macro, we don't have enough used homes selling.
Willy Walker: We're almost out of time on that. Just one thing that I would add to that is that I think the average LTV in Fannie Mae and Freddie Mac's book, which obviously holds trillions of dollars of mortgages, is 55 or 56%. And that's 80% of Fannie and Freddie businesses, single family, 20% multifamily. If there was any time for Fannie Mae and Freddie Mac to be spun back out of conservatorship as far as the health of their book, it's right now.
Dr. Peter Linemann: But you're closer to that than I don't hear any interest...
Willy Walker: There's an interesting one we could spend an hour on this one, but I'd be interested to see more.
Mark Calabria did an interview two weeks ago. Mark Calabria, the former FHFA director under Trump. And he said two things that I thought were quite interesting. One, he said that he and Manoogian had it not been for the pandemic, we're going to get Fannie and Freddie out of conservatorship. And then the second thing is that former President Trump very much it's not only the former President Trump thinks they ought to be out. Legally, FHFA needs to be working on getting them out of conservatorship. The Biden administration has very clearly not been doing that, and I think the Trump administration probably would. So there's been some betting on Fannie and Freddie’s common. It's all the actions I really preferred. But there's been some betting on Fannie and Freddie that if Trump gets elected, they will move to spinning Fannie and Freddie back out. We shall see.
All I'm trying to say is, as consumers who lived through Fannie and Freddie needing $190 billion to be bailed out by the federal government, which they not only returned 190, but they've returned over $100 billion more, the best deal the United States government has ever done. Now would be the time to go do it if we ever wanted to do it.
The final question I have for you, Peter because if you sit there and you say you see GDP growth continuing for as far as the eye can see, you see inflationary pressures being...
Dr. Peter Linemann: I have a really good vision.
Willy Walker: I know it's really good. But this is a beautiful view out here. So we've got GDP growth continuing. We've got full employment. We've got inflation coming down. We've got the United States economy you've said many times not to bet against the US economy. So if you're sitting there with a decision today to move forward on a real estate project, I don't care what asset class, you think the numbers make sense. Is today a go day, a keep studying day, or a pause day?
Dr. Peter Linemann: I would say go. We're trying to go. The hard part of going is capital doesn't want to go, and most of us need capital partners or lenders to get us there. And that gets back to they're not paid to take that risk there. And that's why in a funny way, when it breaks, it breaks quickly. Because once that you're not paid to think that risk is gone… they're paid to take those risks. That's why I think that it's taken me a while to fully appreciate that there are risks, you're paid to take and the risks you're paid not to take. And there are exceptions. And we've seen exceptions, mostly individuals and high-wealth types who are not being paid. They're deciding to take risks. So yes, I'd be acting now and we've got some research in the forthcoming Linemann letter that updates some work we've done. It's a pretty good time when you have these dislocated capital markets to act. It's a bit of alpha if you think about it. A dislocated capital market. Is it surprising that a capital-intensive industry generates a bit higher alpha in a time when capital is scarce if you have it? That's not a wild idea. That's all we find. It's not night and day. It's a bit, but a bit of alpha. Just think of what all these investors go through every day to try to find six basis points of alpha. And what you've got is probably 50 to 150 basis points of alpha if you can access the capital.
Willy Walker: Every developer we talked about, regardless of the asset class over the last few days, sat there and said, “We were developing to a five and a half, and we've been getting six and a half to seven on all of our developments.”
We are out of time. We're going to go to questions here in the room for a second. But to those people who dialed in on the webcast, we had a huge number of people pre-register. And so, to those thousands of people who listened in today, thank you very much for joining us.
Peter, thank you, as always,
Dr. Peter Linemann: A pleasure, and I look forward to you kissing my feet.
Willy Walker: And I cannot wait for the headline, “Walker with the cuckoo clock.” I hope you're right and I'm wrong. I certainly hope so. I don't think anyone wants to misinterpret what I just said. I just would have a little bit of fun with that. Thanks, everyone, for joining us today, and have a great day.
