Most insightful hour in CRE with Dr. Peter Linneman
Willy Walker: Welcome everyone to our first webcast of 2024. I hope everyone had a joyous and relaxing holiday season and into the new year. And I feel like ‘24 is going to be a better year than ‘23, at least from a commercial real estate outlook.
It's nice to be with you, Peter. I think this is our 16th Walker Webcast together, and I rarely get nervous when I get ready for these calls but given that we had 8,500 people pre-register to listen in on this call – I guess there are more ears and eyes today live than we typically have. So, I hope we both bring our A-game to this, which I'm sure you will, I hope I can keep up.
I want to break the call Peter into sort of seven different segments, and some will go quicker than others. The first is a recap of your 2023 performance. I get reviewed by my board of directors and by the capital markets basically every day, I get to do one annual review of you. So I'm going to do that. Then we'll talk about inflation and rates, then macro summary into politics. Get in the game, which I think is the theme of your quarterly newsletter, potential distress where you see opportunity and then your 2024 predictions.
So let me start with a recap of going back a year, because I think that this is pretty telling of you and your team's incredible work and insight into the markets. Just so everyone understands, I began last year's call saying to Peter that if I'd followed his advice the previous year of rates are going to stay low, I might have been in a real pickle because I would have bought something for floating rate dead on it, and it might not be performing to a T. So I want to be very clear here. I both give Peter praise and then also call him out on sometimes when he doesn't get things exactly right. So as I run through this, understand that I am, I think, a levelheaded observer, if you will.
A year ago, 56% of economists were predicting a recession in 2023. You said no recession and positive GDP growth – you nailed that.
Many were predicting a negative year for the equity markets, you said up 7%. The Dow was up 13.7% in 2023, and the S&P was up even more – you got that right.
Crude oil was at $81.70 a year ago. And I pointed out in asking you the question, a Truist analyst who was on CNBC that morning saying that oil was going to go to 130 bucks a barrel. You said nonsense and said that oil would be between $72 and $81 a barrel by the end of the year. It closed 2023 exactly in the middle of your range at $77 a barrel. You got that right.
The ten-year was at 3.42, in the midst of a massive tightening cycle. And I asked you where it would end the year. And you said between 3.3 and 3.8%. I'm not sure when you said that, that you had it going over 5% in October in your mind. But it ended the year, as everyone knows, at 3.8%. You got that one perfectly.
Final one, while the world was saying inflation was out of control, and throughout the year you kept saying that Jerome Powell and the Fed were looking at the wrong data and that that inflation was coming in line. Obviously, as we all now know, you were correct. Late November we got a CPI print, and Powell came out the next day and said we're likely cutting in ‘24. And the markets reacted accordingly.
So I want to start there Peter, because when I saw that CPI report, I said they're not on track to getting to their 2% target. He's going to come out tomorrow after the Fed meeting. And he's going to say, we're not on track to where we want to go. We don't know that we're going to cut rates in 2024. And so when he came out that Wednesday and said to the market, essentially, we feel like we are on track, that we're going to need to cut. That at least caught me completely by surprise. Why didn't that surprise you?
Dr. Peter Linneman: Well, it surprised me only in the sense they'd been so out of touch. And I can't predict when something really out of touch gets in touch. I'm not joking. I've been saying this for months: stop looking at year over year. Look at month over month and annualize. And whether you were doing the PCE (personal consumption expenditure) inflation or CPI. Month over month, they had been bouncing around in the 1 to 2 to occasionally 3% depending on which one. And in fact for the last two months they basically have been zero. Literally zero. And you know, take it the month over month and then the annualized zero, it's still zero.
That overstates where inflation is at because housing has been the main driver of why it's up. So for example, there was a month, I think three months ago where they had inflation month over month annualized at 3.5%. But in that month, they had housing up by about 8% annualized. Well, you and I knew that housing wasn't going, rents were not going up at 8% annualized. At that moment, they were basically somewhere between -2% and plus 2%, depending on what market. When you put it zero instead of 8%, 40% of the index. Suddenly inflation's gone. And it's negative basically. Right? It didn't surprise me. Except where have they been? I don't know what they're looking at. Nothing I'm doing is that. I wish I could tell you I'm doing something incredibly sophisticated and brilliant. I'm just looking at the data, and I'm kind of reading it in real time. Just go to the grocery store. Forget data. Go to the grocery store for the last five, six months. You don't have inflation up. So what can I say?
Willy Walker: At the top of the Letter, you pay homage to our late mutual friend Sam Zell, and you go back to an adage that Sam said in the early 1990s, which was “Survive till ‘95.” That was in the midst of the S&L crisis for those people who aren't old enough to remember it. You change that this time to “Survive to 3.5” and you're saying 3.5% on the ten year. You really think we can get to 3.5% ten year?
Dr. Peter Linneman: Yeah, more or less. And my rationale is fundamental, which is, I think we're going to steady out at 1.5 to 2.25% inflation, which we had been at for over a decade prior to this enormous disruption created by the pandemic. As the pandemic gets farther behind us, it will normalize back out to something like that. I told you, I think we're actually below that now. But if that's the case add 150 basis points, risk premium, that's 3.5%. That is over the previous 20 years prior to the pandemic, that's what the spread was.
Willy Walker: Yeah. So I'm back in the office as you can tell. And we'll talk about RTO in a bit, so just going a little bit deeper on that. You have December inflation at 2%, January at 1.1%, in February at 1.4%. So to exactly what you just said, you see it being down well into their range. The other thing that you point out, which was the reason for the tightening cycle, was supply chains. You do underscore in the Letter the New York Fed Global Supply Chain pressure index, which got four standard deviations above normal in late ‘22 and is currently 1.7 standard deviations below normal, below average in October of ‘23. And so to the thing that you keep pointing us back to, all of the pressure from global supply chain management and back up is not only out of the system, but it's well below norm.
Dr. Peter Linneman: Yeah. I mean, look, you can still find sectors where there's shortages, single family housing being a dramatic example, but there always are sectors. What we had was an entire economy where there were shortages. And that's because when you shut things down, supply came back more slowly than demand. Took a while. And whether it was container cargo, whether it was truck driver, you name it, it was everything. We all know that. Right? Well, those things are starting to normalize. Restaurants are opening that replaced the ones that had closed. Just as a micro example, two of our neighborhood's favorite restaurants closed because they didn't make it through the pandemic. In the last nine months, two new restaurants have opened in those sites. That's what's going on in the entire economy. And it probably overshoots a little because that's what economies tend to do, right? You get a little hot and then you get a little cold.
That was the main driver of that inflation. I think I write in the Linneman Letter, something like, for those of you who don't understand statistics, four standard deviations mean we've never seen anything like it before. And if we have never seen anything like the shortages we had economy wide, it's not surprising you had a spurt of inflation like we hadn't seen before. That's gone. That's gone. And so their focus on the last war, the last war wasn't even created by them. It was created by all these supply shortages. The Fed did not create the supply shortages. They did not make truck drivers not work and so forth.
Willy Walker: So one of the things that you were baffled by was the Fed wanting to get to 5 to 5.5% unemployment. And you said, I've never heard a Fed that wants us to lose jobs in order to get to all of the ‘numbers’ that they studied when they were doing their PhDs in at universities like the University of Chicago, where you did your PhD.
Your numbers today, even though the 3.7 numbers, the Bureau of Labor Statistics, actual unemployment number, your calculation says that that's under by about 220 basis points. So has the Fed actually hit their target?
Dr. Peter Linneman: You know, it's very difficult. I don't think we're there yet. They keep talking about soft landing, right? Soft landing, soft landing. The notion of a soft landing is an airplane coming down and landing smoothly rather than crashing. Coming down smooth. Well, that is talked about in the context when the economy is above normal, it's overheated. That's where that came from. The economy is above sustainable, and you bring it down to sustainable without crashing.
We are still below trend. We're still below sustainable. So they're talking about a soft landing going up. I've never heard of that. And that goes to your point, which is we still have a lot of labor market slack. We still have about 2.5 million people not working that by simple trend should be working. I mean, we have the bodies, they’re just not all back. Most of them are over 62. They haven't come back. Mostly the younger people and the middle age and prime age are back. It's the older who, for whatever reason, did not come back. And that counts. The economy is still under heated. And so the notion of 'let's create unemployment cool and underheated economy’ was just bizarre to me.
By the way, it was so obvious. Again, I'm not that smart. All you have to do is just use the trend of GDP growth in the 2010s and extend it out and you go, oh yeah, by the way, we're still like two percentage points of GDP below that simple trend versus pre-pandemic. That's two thirds of a year's growth. So what's going on in the economy Willy, I think is pretty simple, which is you've got most of the economy trying to get back to trend. That's what I call pent up demand, whether it's for health care or travel, automobiles trying to get back to trend. And you've got, on the other hand, including, by the way, the government. Right. Because the government let people go during the pandemic.
On the other hand, about 20% of the economy being damped by interest rates increases like construction and banking-related items and automobile purchases, things that relate to short-term money. So you've got 20% being artificially damped and 80% trying to catch up. And is it a surprise that net-net we grow and that's story was the story of 2023. I thought it was pretty obvious. And I think it's still pretty obvious.
As the rates come down, especially the short rate, as they lower the short rate. You're going to get back closer to trend by the end of the year because you're going to stop artificially hurting the sectors that are sensitive to short-term. Most notably auto. Auto is under consumed dramatically. That's because about two thirds of the people who buy autos do a loan. And it tends to be a short term loan. So they're getting crushed and they're not buying, but they're going to buy a car. It's not like they are never going to buy a car. They're going to buy a car.
Willy Walker: You do point out the average car is now being owned for 12.5 years, which I'm conflating a lot of things here. But you also talked about oil consumption and it's amazing how much the economy is growing and how many more cars there are on the road. And yet our aggregate oil consumption has stayed basically flat, which plays to efficiency. But let me poke in for a moment on what you just said as it relates to GDP and under production and under consumption. This is a consistent theme in the Linneman Letter, which is the undersupply of housing since the great financial crisis in both multifamily as well as single family and also auto production.
You quantify it and you say currently if we would get to trend on housing, that would add $2.2 trillion to GDP. Then if you got to trend or to where we should be on autos, that would add another $642 billion to GDP. And my mind went to first is that old adage, “What's good for GM is good for the United States” still exists today. But more specifically, Peter, if you were President of the United States for a day, what would you do to spur either more housing development or more auto production?
Dr. Peter Linneman: Housing would be hard because it's largely controlled, as you know, at a local level from a Nimby kind of. And I don't think there's a lot they can do at the federal level. They can do little things. I guess the main thing I would do on housing would be Federal funds to local jurisdictions, which there's a lot of transfer payments to goals that increase housing supply and reduce housing costs. I'm not going to give you as much money for your schools or whatever unless you produce more housing, right? I'm not going to give you as much money for all the programs we transfer to you, unless you do something like that on the housing side, because they've got to get local areas to allow more housing.
On auto, try to convince the Fed to lower the rates because all that has to happen is, they lower the rate of those people who are waiting to buy a car. They'll buy a car. A short term rate of three, but they're not going to buy into the short term rate for five and a half. Now you say, well, the president doesn't control that. So I don't quite know how to get around that. This is why I'm not a politician.
Willy Walker: One of the things I would point out to people, there's an article in today's Wall Street Journal on the cover, which talks about a residential development by the owners of the Bal Harbor Mall in Miami, where they passed legislation to allow you to basically circumvent the approval process from a zoning standpoint, if you were to build affordable housing. And by the way, affordability in that article was quoted at 120% of AMI. That's a very generous affordability level. And the moment that the developers come out and say they're going to three towers, two market rate and one affordable at 120%, everyone jumps up and down and says the worst thing in the world because they're going to send shadows and all sorts of stuff. So it is really interesting how much of this is at the local level. And the only way to get more supply of housing is if you have local jurisdictions and states that say, we've got to do something about this.
Dr. Peter Linneman: And it's very tricky Willy, because here's how I think we got to this staggering shortfall, 3.5%, roughly just around 100 million single family stock of single family homes. And we're 3.5 million short. Just roughly. How did we get there? From 2002 to 2006, we built 2.3 million more homes than we needed for people in four years. That increased NIMBYism enormously. And at the same time, the industry shut down building new homes because of the dynamics of the housing bubble and the collapse.
You can imagine NIMBYs saying, (I'm oversimplifying this) we're going to let you build 1,000,001 homes a year, single family homes. We're going to make your life miserable. We're going to make it expensive, but we're going to let you build a million one. And then what the industry said is, never mind, we're only going to build 400,000. But we still are adding people. You know, you were adding bodies, but it used up some of the excess. Well, for four years it burned through the excess roughly. And then the industry said, um, well, you may let us build a million one, but we're only up to 400,000 still. Well now suddenly out of 700,000 shortfall. And then they did it again and they did it again. And you get to the point where there's this 3.5 million unit shortfall, and NIMBYs are saying, you know, we're not going to let you build 1.7 million homes and start eating into that shortfall. No way. Zero way. It's on you, dear developers, not on us, that there's a shortfall. Don't blame it on us. You could have built them. We would have approved them. And in many cases, you know, they approved them and didn't get built. And so it's an odd dynamic.
It's the best thing multifamily has going for it is a 3.5 million units shortfall of single family. Why? Because those people are going to rent longer and build up money for down payment. And if you do some simple math, it's going to take several years more. Think of a person that might normally be a renter for 15 to 18 years of their life. They're going to have to rent 3 to 4 more years. That's a huge percentage change in rental demand, right? If you just think of it in that way.
Willy Walker: You point out that the Wells Fargo Housing Affordability Index is at, I think, an all-time low at 38%, so people have that in context in 2012 and I think it was, the housing affordability index was at 72%, which meant that someone making the median income in America could afford 72% of the existing and new housing stock. Today, that number is at 38%.
Dr. Peter Linneman: Yeah. And the dynamics, by the way, the political dynamics of this are fascinating, which is the person trying to buy the home and the community says, oh, it's so expensive, I can't come up with a down payment, blah, blah, blah. They don't vote. They don't live there, right? They are living somewhere else. And the people in the community are going, yay! It's pushing up my home price. And the home value is a big part of the asset that these people have. And you go, yeah, but that may be your kid that is unable to buy. And they'll say, well, I'll take care of my kid individually. Not in aggregate, right. So if I like, I can give my kid a transfer or something if I want. So the dynamics of it are kind of amazing. Namely, the community wants to be NIMBY cause it pushes up home values. Yeah, and that's a winning political position.
Willy Walker: So I want to focus on two issues as it relates to debt. The first is our federal debt, and the second is consumer debt. So bear with me for a second as I throw out a ton of numbers from the Linneman Letter so I can kind of get down to the specific numbers that I want to have you comment on.
So you put in real household net wealth today stands at $144 trillion at the end of Q3 2023, $144 trillion. That's $431,000 per capita, or $1.1 million per household. So that's a big number. Below that, we've got $26.8 trillion of GDP. On top of that, we have about $20 trillion of household liabilities, with home mortgages being 63% of that $20 trillion number. And you point out that the nice part right now is a huge percentage of those people of that 63% of home mortgages fixed their rate when rates were really, really low and have a 30 year fixed rate mortgage or a 15 year fixed rate mortgage, and don't have to worry about the fact that rates have gone up.
And I have said this before, and I will say it again, anyone who was critical of Fannie Mae and Freddie Mac's role in our government and in our economy should be thanking their lucky stars that we have Fannie and Freddie, that we've taken all that paper but long term fixed rate loans on it, because, as you pointed out 2 or 3 Letters ago, if we had been Japan, Canada or the UK, most people would have a five year floating rate mortgage and they would be being strangled right now by those floaters. So a very important piece.
You then though, go to the deficits that are running and all this is going to come down to our federal debt. You go to the deficit, and you seem to just kind of blow through the fact that right now, the CBO projection, you do point out the CBO's numbers are iffy at best, okay. So you're like, don't bank anything on CBO projections. But with that said, there are at least a number in the sky that will run a $1.7 trillion budget deficit each year between 2024 and 2027. And then you go to the federal debt, and you say $32 trillion of federal debt. You back out of that intergovernmental, which is about seven and a half, and then you take out another five off of that, which is to the Fed, and you get to a net net debt number of $20 trillion. So $144 trillion of net worth, $26 trillion GDP and $20 trillion of net net fiscal debt, or a federal debt with a deficit per year of $1.7 trillion over the next three years. And yet I read all of that it scares the you know what out of me. And you say, not a big deal. Please dive in and tell me why that's not a big deal.
Dr. Peter Linneman: Okay, so let's do this in pieces. The $144 trillion net household debt is already net of the households personal debt. Right. So that's already out of that. Okay?
Willy Walker: So I would not have net debt of $144 but of personal net wealth.
Dr. Peter Linneman: Yes. But their personal debt is already netted out. That's what is all I mean. And let's just say with a $20 trillion federal debt outstanding. So that says net net is really only $120 trillion. Not the federal debt off of $140 trillion. And you'd still say, that's the richest society I've ever seen in my life. Now, in fact, it wouldn't be $120 trillion. Why wouldn't it be 120? It'd be closer to $131 trillion. And the reason it'd be closer to $131 trillion is as we're paying off that federal debt from our wealth – I'm paying off you for the bonds you hold. So it wouldn't be $120 trillion. It'd be closer to $132 trillion. And I don't mean to be flip. Can you tell the difference between $140 trillion and $132 trillion in a country that the world has never seen anything like it in a big country. I mean, yeah, Liechtenstein or Monaco or something, but a real country, right, with lots of people.
So the aggregate is nothing. Put it differently. When the boom dies, they're going to leave more than enough money to pay for the debt and run up on their watch. Okay. Fair enough. The federal debt and the personal debt run up on their watch. More than enough. Fair enough? So that's why I don't worry about it. And that's it. Then let's go to the GDP context. So I've got $26 trillion of income annually and I've got liabilities of $20 trillion. I could pay that off if I wanted in about nine and a half months.
Willy Walker: But that's saying that the government gets all $26 trillion? The government only gets seven.
Dr. Peter Linneman: I'm talking about capacity. And I'd say what building owner could, not would, have enough cash flow to pay off their debt on their properties with nine and a half months of property income? The answer is almost none, right? Yet you view that as a healthy level of debt, right?
If somebody says, I'm going to borrow such that it's 75% of my income. So think about it. I have a five cap on $100 million property. I have a five cap, and I'm only going to borrow $3.5 million. I think you view that as conservative right? That's all we've done as a country. That's all we've done as a country. Okay, now that doesn't frighten me, therefore. Okay? Any more than would frighten me if you had $3.5 million debt on a $100 million asset with a $5 million income.
What does worry me? What worries me is not the $1.7 trillion a year projected deficits. It's what the hell are we spending it on? And I don't care whether it's a deficit or taxes. What the hell are we spending it on? And we're spending $4.7 trillion of our money, if you will. What are we getting that's worth $4.7 trillion? Everybody can arrive at their own answer to that question. If everybody told me, you know, the $4.7 trillion that the federal government is spending. We're getting fully our money's worth on every penny of it, then God bless. And if you told me, I don't think that's true. And we're only getting, let's say, $4 trillion in value on our $4.7 trillion and spending, the loss is the gap, not the deficit. The deficit is just how did we decide to pay for it? Did we decide to pay for it with people who are here today or are people who are going to be here tomorrow, and a lot of the people who are going to be here tomorrow already, the people who are here today.
So it's the latter number. It's the spending. Are we getting our money's worth? Because if we're just wasting our money, what's the point? Hopefully, you get my point. I mean, we have $140 trillion in wealth. We could pay it off. We’d still have $132 trillion in wealth. But remember, we have a clean balance sheet at that point for the country moving forward. We could pay it off in nine and a half months if we wanted to. It's the equivalent of having $3.5 million debt on a $100 million building.
Willy Walker: One point further on these macro numbers, and then I want to dive on the consumer because you give some really good data as it relates to the consumer. And I continue to hear your concerns about credit card debt. And so I want to debunk that concern. But yeah, you point out Social Security, Medicare and Medicaid currently absorb 11.3% of GDP, and 60% of all federal spending. To give that context, another data point you put in there is that all corporate profits after tax in the United States reached a peak of 11.1% of GDP in Q2 of ‘21 and now sit at 9.6% of GDP. So we are spending today more on Social Security, Medicare and Medicaid as a percentage of GDP than all the companies in the United States added up after tax. I think it is a very interesting number as it relates to where we're spending money and where we're investing.
Dr. Peter Linneman: Before you leave that, as somebody who is soon to turn 73 – there's nothing wrong with those Medicaid, Medicare and Social Security payments. Just I want that on the record.
Willy Walker: I appreciate that. And therein lies the problem, because you vote and a lot of people on this call are saying the younger don't vote.
So a couple numbers here. Household debt as a percentage of disposable personal income sat at 81.4% in Q3 of ‘23. That's down from a peak of 123% in 2008, just prior to the great financial crisis, and also down from 88% pre-COVID. So Q4 2019, that number was at 88%. So we're massively de-levered from where the consumer was pre-pandemic. And the other data point that I put out there is that you point out that credit card delinquencies were at 2.6% in Q4 of 2019. They are currently at 3% at the end of Q3 2023. And so while up, they've come up dramatically since the depths of the pandemic, when credit card delinquencies were at zero because the federal government was pumping trillions of dollars into the economy. And so people are seeing credit card delinquencies go from 0.5% to 1% to now 3%. And they've seemingly hair on fire that we've got this big crisis coming up as it relates to credit card debt and the consumer's over-levered. But you point out that in comparison to pre-pandemic, we're 40 basis points off of where we were?
Dr. Peter Linneman: Yeah, I mean, and you have to remember one other thing. Everything you said is right, they’re up from an unbelievable low and still below normal delinquencies. And remember when you borrow through your credit card, they're assuming you're going to default at some rate that's already built into the pricing of it all. It's only to the extent that it defaults beyond what's billed into the pricing, you get a problem. That is not the case. That's the relevant point about it's below normal. Now there's another issue about credit card debt. And I write about it a little bit and I've spoken about it a little bit.
Willy Walker: It's a super important point. It's a super important point.
Dr. Peter Linneman: Well, you know, we all here steadily credit card debt keeps rising. Credit card debt keeps rising. And the implication is there's a profligate consumer out there overspending their needs. Well, everybody on the call knows that you have a grace period on your credit cards, typically 21 days, that if you pay your balance in 21 days, you pay no interest. And you say, well, how does the credit card company make money? The way they make money, a few of them charge you for the card, put that aside. But most of them are charging the vendor when you use the card with them. So how are the credit card companies making money every time you charge a purchase? They get a scrape.
And think about how even old guys like me now are buying their sandwich at the deli using a credit card rather than cash. That wasn't true ten years ago. You go back 30 years ago. So what's happened is credit card usage and enhanced major credit card debt, because if I pay my debt off on the 10th day of the grace period, it registers as debt until they get it right. So there's debt there. Credit card debt is going to just keep rising until we eliminate cash and checks, because what you're getting is this massive switch from using checks and cash to using credit cards. Of course it rises.
Now, I've tried to find out how much. Carefully guarded industry secret. I'm not joking. Very carefully guarded as best I can figure out probably 50% and rising of credit card debt isn't real debt. It's simply because of convenience and it is the bulk of the growth that's occurred over the last 20 years, ten years, two years. I think that's an important thing to bear in the back of your mind, even though we can't quite put a pencil on exactly how big that is.
Willy Walker: Yeah. I mean, I think total outstandings on credit cards passed $1 trillion during this year. To exactly your point, $1 trillion sounds like a really big number, except for the fact that if $500 billion of it is you and me using it for convenience’s sake and never paying a penalty on it, it's not really debt, it's just a service.
One other thing on this, and then I want to move on to canaries and some other stuff. Debt service ratio, something that you and I have talked about a bunch. It peaked at 13.2% in 2007, it bottomed at 8.3% in 2021, and it's sitting right now at 9.8%. So it's sort of right between those two data points closer to the low than the high, but it's right in the middle. When does that number start to concern you, Peter?
Dr. Peter Linneman: That number I reported and as you know, there's always this thing you can drown in a puddle of water that's on average, one inch deep. I think that number is possibly the best example I know of that phenomenon. And you see it in real time in your business.
Willy Walker: So it's all relative? What you're basically saying is it's all relative, you don't get to 12 and start to get upset just based on whether we're in a recession, non-recession, there's so much more to it?
Dr. Peter Linneman: There's a lot to it. And my guess is you're probably right that if it starts getting 12, 13, 14, you start. But is it long or short term? Is it fixed or floating? What kind of property is it? Etc.
Willy Walker: I got it. Okay so quickly on canaries and then I want to get in the game. Canaries you're at nine out of 50, which is a number that for the past couple I think we've been right around there. The one that I want to poke in on is a misguided Fed. You've still got a misguided Fed at 4 or 5 dead canaries. Okay, so how can you still be at 4 or 5 after Jerome Powell came out and said what he said on that Wednesday? I would have thought he at least resuscitated one of the canaries.
Dr. Peter Linneman: No. I look at what people do, not what they say. If I'm right about inflation and I can't be that wrong, that it's down around 2%, a 5.5% short term rate is insane. It is insane when inflation was running 2% and the short term rate was zero. I mean, it's the flip side of that coin. It has different distortions, but it's the same problem. And they should have the short term rate at least to 3.5% right now and arguably 3%. So they got a lot of margin to go. When I see them actually cut, I think one of the canaries will come back to life. But until then, they're just talking. It's like, I'm watching the Eagles crumble in real time. You know, this is a replay of the Phillies folding in 1964. You know, with the pennant stretch. But it's one thing for the coach to come out and say, we're going to play a hell of a lot better this Sunday. I'm not going to give him credit till I see him do it on Sunday. You know.
Willy Walker: I will say my friend Will Blodgett’s New York Giants are a formidable team that beat your Eagles last week. So don't take it all to the Eagles.
Dr. Peter Linneman: It made them look like the greatest team, a Vince Lombardi team.
Willy Walker: So let's go to get in the game. That's kind of the theme of this letter. I'm quoting you: “Investing in times of capital markets, turbulence yields outsized 7 to 10 year returns. Many real estate investors today are making type two investing errors.” What's a type two investing error, Peter?
Dr. Peter Linneman: Okay, so I do that just to impress people that I know Statistics. Or at least at one point I knew statistics. Type one error for those of you who remember statistics is what is the possibility of believing something is true when it's not? If you do that in an investment context, what's the likelihood that I invest in something that I wish I hadn't if I knew everything? And that's what most of us focus on. If you think about it truthfully, most of us as investors focus on, I don't want to invest in something and find out I shouldn't have.
But there's another risk. And the risk type two error is that you don't believe something statistically that in fact is true. And there's a tradeoff between type one and type two. And an investing type two error is I don't invest when I should have. I think people are making that error right now. I think they're overly mechanically plugging into models – in a sensible way, it's not like it's stupid. Don't misunderstand. But it misses the fact of how dynamic things are. It misses the fact that in times of capital market disarray, if you come back 7 to 10 years later, you tend to find not only did you do okay, you did better than okay. And that's not factored into the models. If you factored that into the models, you'd be doing it. And I think there's a type two error which is a lot of people that do have money aren't doing things because they're afraid of making a decision and finding out that they were wrong (that's a risk) and they're less afraid of not making a decision and missing an opportunity. And our friend Sam Zell, I used to have conversations with Sam. You might find it funny. When Michigan scored their first touchdown the other night, my first thought was, Sam must have really enjoyed that run. Now I realize Sam's dead, you know? So that was him. But I had these conversations with Sam (Zell), and I'm not going to imitate his voice. But those of you who know it, think of it when I say this, he would say: “Everybody tells me they want the opportunities I had from '73 to '75 or '80 to '83 or '90 to '94 or right after 9/11,” and he says: “They don't really want them. They don't really want them… because when those opportunities arise, people back away rather than step up.” And he wasn't the only one who stepped up, but disproportionately, people stepped away rather than stepped up. And you can imagine Sam kind of cackling, going: “They say they want them, but they really don't want them.” It takes a different type of belief.
Willy Walker: On that and playing on the Sam theme, there was a Businessweek cover in the 1990s with Sam's picture on it that said, “Grave Dancer.” That was the title. So you say in this Linneman Letter, if you're waiting for a lot of grave dancing, there's probably not going to be a lot of grave dancing. And you put out some stats as it relates to charge off rates at banks and things of that nature. Let me go a little bit more. You know, we've been talking about trillions of dollars here and trillions of dollars there. And it all is so big. And if you stay on the pure macro, it obviously you can play on the macro play. But people who are listening to this call have micro decisions to make every single day about: do I sell an asset? Do I buy an asset? Do I finance it this way? Do I do that?
So on CLOs, we did an analysis at Walker & Dunlop on the $56 billion of multifamily debt that's outstanding and CLOs that were issued in 2021, 2022, not much in 2023, but ‘21 and ‘22. And based on our analysis, we think that about $20 billion of that $56 billion is fine. We looked at well over 1.0 debt service cover. It's great collateral. Remember this is just multi. This is just multi. 41% of it 41% or $23 billion is at or below a 1.0 debt service cover. And we put a big question mark as it relates to the performance and the ability to continue servicing that debt. And most glaringly, $12 billion or 22% of it is got at an average DSCR of 0.7. Let's just take a conservative look at it, Peter, and say that this is all 50% LTV debt, which we know it's not, but let's just call it 50% LTV debt. So as you're sitting there, you've got $70 billion of multi assets with a capital structure right on them right now that is not sustainable. So when you say there's like no distress, no grave dancing: I ask you, well how do you then foot $70 billion a multi out there that has a capital structure that just doesn't work today?
Dr. Peter Linneman: Okay, great question. Two answers. One, Powell cuts the short term rate by 100 basis points or 150 basis points over the next year. How much of that debt suddenly does cover? Because the bulk of what you're describing, I suspect, is floaters.
Willy Walker: They're all floaters. You got it.
Dr. Peter Linneman: So 150 basis points it's not going to make them brilliant, but it's going to make them survivable. And if they're survivable, the current owner is going to figure out a way. Or the current lender is going to figure out a way to make the current owner get there and so forth.
So it only takes 100-150 basis points to get there. And we just talked about that. By the way, 150 basis points would still only have the short rate down to four. In a world where inflation would probably be 2%. So it's still abnormally high okay. So that's one way.
The second is just because there is a bad capital structure doesn't mean there's an opportunity. If I've got staggering amounts of money willing to step into that property, it's not going to be a great opportunity. It's going to be an opportunity, but it's not going to be a grave dance. And so the one of the numbers I put in, or one of the quick calculations I put in, is I happen to be chairman of Rockefeller Center, trying to sell the property in 1993-1994. At that moment, there were no sovereign wealth funds. At that moment, pension funds absolutely were not putting a dime into real estate. At that moment, there were no notable REITs. At that moment, private equity, real estate private equity in aggregate, had about $2 billion in aggregate. By the way, of that aggregate, 85% was already committed. So when you say, well, how much was really available, dry powder could have been as little as a couple hundred million dollars. Couple hundred million dollars of available dry powder private equity. And you go, okay, let's contrast that to today. How much dry powder private equity is out there? And the answer is I don't know exactly 200 to 250. How much sovereign is out there interested and willing? I mean, we both know where to go, whether they'll do it is a different matter, but you know where to go. How about REITs? Well, we have well capitalized REITs, so let's assume a really good opportunity comes up with a 0.9 coverage, and rates are on their way down. You think that's going to be a grave dance or that that's going to be a heavily competed situation?
Basically the new owners are going to come in and price that. Now, obviously, if it's a crap building in a crap location, that's a different issue. But that's not a grave dance opportunity. That's difficult. So this notion that I'm going to find that 95% occupied and they have a 0.9 coverage and they're upside down on their capital structure and so forth, and I'm going to steal it. There'll be a few, and I'm sure you'll be able a year from now to point out what, $5 billion of such deals? And I'm sure they're going to happen. Or you may be able to point out $6 billion of such deals over the course of the year. But that's hardly a mass of grave dance possibilities.
Willy Walker: In looking at where construction dollars are going, because I think this is a really interesting forward view that you put in the report. Construction spending T12. Let me just run through the numbers quickly and then get you to comment on it. Office = $81 billion, which surprised me. Industrial = $263 billion. Retail = $43 billion. Lodging = $22 billion. Multi = $129 billion.
Let me run back through that in percentages. Because when you hear those, it's hard to kind of put them under context. Office = 15% of construction dollars are in office today. Industrial = 48% of construction dollars are in industrial. Retail = 7%. Lodging = 4%. Multi = 24%.
Pretty clear from those numbers, Peter, that the two asset classes that people want to build and own are industrial and multi.
Dr. Peter Linneman: Yeah, there's no doubt. And the offices as we've talked about are a bit odd because you essentially have a model, it could turn out to be right. Which is if I build it, they will come because they want the latest and greatest and we'll just obsolete the old stuff. Because otherwise it makes no sense to have construction levels in office.
But industrial, still is undersupplied and multi is in a few markets oversupplied, in a few markets undersupplied. There's some near term softness as we go through this year and early next year. Remember how screwed up the pipeline got by the pandemic and the shutdown. So what would have been a fairly smooth pipeline got shut down pretty much in 2020. But then, you know some of that starts coming out in 2022. And a lot of it got backed up into 2023 and into 2024.
So, what you're going to get is softness in multifamily this year. But you're going to make it back up in late '25, '26, and '27. Why? Because multifamily construction starts have fallen at least by half, in what, six months? Something like that.
And as you and I have spoken about and I've spoken about this with major owners of multifamily and major developers, none of us can even figure out where the multifamily starts are coming from that makeup the multifamily starts, we see. You know, you get a sense they're more like 200,000 than 300,000. Mostly affordable and niche stuff and some opportunity zone stuff and some 1031. But it will balance out over time. So multifamily still looks pretty good.
And I come back to where we kind of started with. The best friend multifamily has is single family that is fundamentally under built. If a major competitor fundamentally cannot produce enough to meet the demand of the people who want to buy them, it's good for you. If Toyota cannot make enough automobiles to match the demand of people who want to buy Toyotas, it's good for Honda. It's good for Ford, it's good for GM. That's what's going on with multifamily. And the difference is Toyota will figure out a way to ramp up. I don't know, as we talk about, that single-family can figure out a way to ramp up to get rid of that situation.
Willy Walker: A real quick one because I got a bunch I want to get through before we loop up and we're running out of time. As it relates to construction, the Linneman construction cost index is up 10.3% since pre-pandemic. Yet the Turner construction building cost index is down 2.3. Why is there such a disparity between the Linneman construction cost index and the Turner index?
Dr. Peter Linneman: They use a lot more steel. They use a lot more. If I had to put it in one simple way. I'm not saying right or wrong, Turner is pretty good. That's why I do them both. They're much more geared to steel concrete reinforced high rises. And if you think about it, that's what Turner does, right? Remember, Turner wasn't doing this as an exercise. They were doing it to try to give a sense of people who use them. All right. And so they think of a Turner. They tend to do big steel reinforced. And steel was a major shortage issue. And then that shortage has reversed. I had to finish the sentence. That shortage reversed.
Willy Walker: A couple quick things on assets and then I want to go into predictions. So on hospitality, I was really surprised that real RevPAR is down from $98.35 pre-pandemic to $93.03 today. That defies every hotel that I go to today. I mean, it just feels like every hotel is overbooked and overcharging. So I was very interested to see that the actual RevPAR number and occupancy has gone from 66% down to 63%.
Dr. Peter Linneman: But that's in real terms. That's in real terms. That's adjusted for inflation.
Willy Walker: Right. Okay. Make sense.
Dr. Peter Linneman: And what it really says is we're not all the way back yet in terms of demand.
Willy Walker: Right.
Dr. Peter Linneman: We're back. But we're not all the way back to where we should be. In real terms.
Willy Walker: And I just talked about industrial and how industrial has 48% of the construction dollars going to it right now. You point out in the Letter that industrial vacancy rates have gone from 3.3% pre-COVID to 2% today, 2% vacancy in industrial.
Dr. Peter Linneman: Yeah. And what's happening there is we talked about it before, which is that as online sales increase, they use a lot more warehouse space than traditional retail uses. So I just watched A Wonderful Life over the Christmas holidays, every time you hear a bell, it means there's an angel getting its wings right. Every time you see something bought online, it means a whole lot more warehouse space is needed than traditionally. And we're still trying to catch up there. We're still trying to catch up there.
Willy Walker: All right, so on to predictions. I got to get you on the record because I love doing my look back. The first one that I just think is an interesting anecdote is that you talk in the Letter about AI's impact on the economy versus Ozempic’s impact on the economy, and you put out there and I thought this was really amazing, Peter. You put forth as it relates to our federal spending that you think that Ozempic and these weight loss drugs could save us 2 to 3% of GDP in our overall health care spending in America?
Dr. Peter Linneman: Sure. You had Mike Roizen on with me some year and a half ago or so, and we spend a tremendous amount of money on problems associated with being overweight. And you could argue, probably 70% to 80% of medical expenditures on that in one way or another. And the Ozempics of the world could be an amazing partial solution to that issue. And with it will go medical and health benefits, of which Medicare and Medicaid are major payers for those same. So if I lose a bit of weight and I no longer have to take blood pressure medicine, that saves Medicaid and just that kind of stuff, you can add it up.
Willy Walker: All right. So first question: How many rate cuts in 2024?
Dr. Peter Linneman: Five.
Willy Walker: Whooo. From your lips to God's ears. Ten years at 4.01 today. 12/31/24 prediction?
Dr. Peter Linneman: It'd be 3.43 3.50.
Willy Walker: My friend Bob Nichols at Monarch. He and I have a bet about that. You're a lot closer to his prediction than mine. Dow is at 37,567. Are we up or down in the equity markets on the year?
Dr. Peter Linneman: It'll be up, and it'll be up 6-7%.
Willy Walker: I shouldn't allow you to do the same thing year after year, but I'll accept that.
Dr. Peter Linneman: Well, what's going to happen is they're going to react well to rates, and the economy is going to hang on. You could get a big run but predicting 18% seems silly.
Willy Walker: Oil's at $72.29 today. At year end?
Dr. Peter Linneman: Probably closer to $68 to $70. Could even be as low as $65. The U.S. in the last quarter of last year, pumped more oil than any country has ever pumped in the history of the world.
Willy Walker: Yep. Energy independence.
Two final ones. You have GDP predictions for 2024 through 2027 that sit around 2.5% on GDP growth. Any change to that depending on the outcome of the November election?
Dr. Peter Linneman: Not notably. No. It matters to a second order. It matters to particular industries. And it matters to particular individuals. Some win more and some lose more. Politics is more about who wins and who loses than the overall economy, tends to be second order in the overall economy. We love to talk about it. I love to talk about it, but as I look at it, it's not big.
Willy Walker: Okay. And then the final one is, I'm not going to put you on the spot for the election outcome, which will happen between now and the call that we do in January of next year. But maybe an easier question. Does Jerome Powell get renominated as Fed chair in May of 2026?
Dr. Peter Linneman: No. And on the political, I won't make a prediction, but I'll give a New Year's wish. I just wish we would have a President who doesn't look at me at 72 years old and says, how are you doing, sonny?
Willy Walker: On that note, I can say, how are you doing, my friend? And it's great to start 2024 with you, Peter. Thanks.
The Linneman Letter is fantastic. It's longer than usual, I will tell people. It is chock full of great information. So if you haven't gotten a copy and read it, you ought to. My summary of it is just that, a summary and not really the deep dive that needs to happen to really guide your investment decisions. Always a pleasure. See you next quarter, my friend. And I hope everyone has a great day.
Dr. Peter Linneman: Happy New year. Thank you.
Willy Walker: See you.
