Webinar: State of the Commercial Real Estate Market

A Webinar with Dr. Peter Linneman and Our CEO, Jilliene Helman
This webinar is about the state of the commercial real estate market and Dr. Linneman’s insights and outlook for 2024.

Dr. Linneman, the founding principal of Linneman Associates, is a leading expert on commercial real estate. He holds both a Master’s and Doctorate in Economics and has had a distinguished academic career at both The University of Chicago and the Wharton School of Business at the University of Pennsylvania. He has published over 100 scholarly articles and is the author of “Real Estate Finance and Investments: Risks and Opportunities” and the quarterly Linneman Report.

Transcript

Jilliene Helman:

Hi, and welcome to Mogul Insights. I’m Jilliene Helman, your host and the CEO of RealtyMogul. And I’m joined today by Dr. Peter Linneman, who’s a real legend in the commercial real estate industry. So we’re so excited to have you with us today. Peter. Thanks for joining.

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Dr. Peter Linneman:

Well, thank you for having me. It’s my honor and pleasure.

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Jilliene Helman:

This is the second time that I’ve had Peter on, so I’m excited to have him on again and to learn the latest of what’s going on in all things in the economy and in real estate. Before we get started, I do want to share a few requisite disclosures. Today’s conversation is not a recommendation or offer to buy or sell securities. Information discussed today may include forward-looking statements and is for informational purposes only. Forward-looking statements, hypothetical information calculations are inherently uncertain. Past performance is never indicative of future performance, and none of the opinions expressed by Dr. Peter Linneman are the opinions of RealtyMogul. So we’ve got that out of the way, and I really want to give a little background on Dr. Peter Linneman.

He’s just such an impressive and also humble guy, but I don’t think you’re going to share your background, so let me do it. For almost 45 years, Dr. Linneman has a unique blend of scholarly rigor and practical business insight. He’s gotten accolades from all around the world. He won PRIA’s prestigious Grass Camp Award for Real Estate Research, the Wharton Zell Lurie Real Estate Center Lifetime Achievement Award, he’s been named one of the most 25 most influential people in real estate, and one of the 100 most powerful people in New York real estate. He’s advised leading companies, served on 20 public and private boards, and received a master’s and doctorate in economics under the tutelage of Nobel Prize winner Milton Friedman, had a very long career at both the University of Chicago and the Wharton School at the University of Pennsylvania, written over 100 scholarly articles, eight editions of an acclaimed real estate finance book, and also the widely read Lineman Letter, which is a quarterly report that he continues to publish today. So it’s a real joy to have you on with us, Peter.

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Dr. Peter Linneman:

Well, you’re very kind and thank you. And I can’t tell you what a pleasure it is.

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Jilliene Helman:

So let’s dive right in. Set the stage for us. Right. It’s December 2023. We’re in a really particular time in the market. The latest inflation print just came out. So I know that you’ll speak to sort of inflation, what you think about inflation, what the Fed thinks about inflation. We have these rapidly increasing rates. Meanwhile, supply chains feel largely back to normal. There are signs of a healthy economy. I think if you look at job creation, we’re back to pre-pandemic levels in most markets, and yet you see that consumer confidence is lower today than it has been in the past. What’s going on? What are you seeing in today’s market? What’s going on?

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Dr. Peter Linneman:

All right. I was talking to a friend the other day, and I said, “you have to go back three and a half years ago to understand the distance we’ve come and what we went through.” Three and a half years ago, the price of oil was minus $10 a barrel. You had to pay someone to take oil from you. And we had 23% of the labor force collecting unemployment insurance. And it’s easy to forget that disruption that were going through didn’t disappear instantly. We’ve come back a long way. GDP accrued measure of the economy is still probably 2% or so below pre pandemic trend. That’s almost a year’s growth. So, another way of saying it, in the last 3.5 years, we’ve grown 2.5 years. And we’ll make up that year’s growth, not in a day. We’re making it up over time. And so, for example, if you look forward over the next two years, we’ve got the normal two years of growth that the US. Economy can generate because of its entrepreneurship. It’s this, it’s that quality of labor source, et cetera. It’s got the normal two years of growth plus one year pent-up. And what’s been driving the economy beyond normal is that pent up coming out. And it comes out in a lot of ways, and it still has more to come out.

For example, travel and tourism. I know you do some hotel stuff. Travel and tourism is basically where it was four years ago. Now, over four years, we’ve added population. GDP has grown. We’re richer. We should be traveling probably 8% more than four years ago. We’re traveling the same amount. Still pent-up. We’ll get there. If you walked out of my apartment where I’m sitting, you could get to University of Pennsylvania’s Medical Complex and Thomas Jefferson’s Medical Complex in, like, four minutes. People forget that basically in 2020, everything elective was shut down. So, you’ve got a huge pent-up demand for medical services that is still working its way through the system. Autos. At first, we wouldn’t go out to buy autos. Three and a half years ago, would you have gone out to buy an auto? You couldn’t. The auto dealerships were closed. They were viewed as not essential and so forth. And then just by the time you worked up enough comfort to go out, they didn’t have chips and other material components, so you couldn’t buy them. So we still have a lot of pen up demand for autos. So you can go other sectors. I’m just trying to be precise. So that pent up demand, as well as the normal force of the US. Economy, which is around two and a quarter to 2.5% growth a year, is still there. And I keep saying we’re not going to have a recession as long as that’s. There people say, well, what about the high interest rates? Don’t interest rates choke off growth? Not generally. And that’s what we’ve just lived through. And you mentioned Milton Friedman 50 years ago. 50 years ago. I listened to his lectures and he said, “these macroeconomic models make no sense.” And I’ll give you a modern version, very simple modern version.

The notion is that if the Fed raises the short-term interest rate, you suddenly go, I’m not going to eat out tonight because the interest rate is 25 basis points higher, and I’m not going to invest in a new plant that otherwise would be highly productive because the interest rate. Okay, well, first of all, 35% of the economy is state, local and federal government. Do you think they respond to short term interest rates in their decisions? Not at all. And you can look at the data. This is not just theoretical. You look at the data and they didn’t reduce employment growth as the interest rates went. So there’s 35% of the economy now. Let’s take 18% more. 18% of the economy is health care. Had you been pregnant two months when the interest rates started going up, you didn’t go, oh, gee, I hope they have the rates down in seven more months, otherwise I’ll have to hold the child in until rates come back down. Well, that’s absurd. Or if I had a heart attack right now, I wouldn’t say, no, don’t take me. Let me lay here until the interest rates come back down. So health care is largely immune. There’s 53% of the economy never mentioned that in your macroeconomics class. 53% of the economy essentially interest rate insensitive. Then you say food and other staples, toilet paper, et cetera. One third of the people buy cars without debt. And when you get down to it, there’s only about 20% of the economy that’s interest rate sensitive.

Really? Interest rate sensitive development because they use a lot of short-term money. Banks because they use a lot of short-term money. So I’m not saying nothing. So you can imagine this normal growth plus pent-up demand versus 20% of the economy. That’s a bit interest rate sensitive. I know who’s going to win, all right? And we’re seeing who’s going to win. It’s not like the normal situation where the economy might be fragile, and then you do the 20%. This is quite the opposite. So the economy is quite good that way. And then I do inflation. I was saying inflation is about how fast are prices rising now. That’s what you want to know. You don’t want to know what prices rose from 1807 to 1861 for policy today. You want to know now in real time. Well, if you asked me take another example. If you said to me, “Peter, I’m very worried that you drive quite fast and I’m worried about your health, and I don’t want you to die in a car accident, and so how many miles have you covered in the last hour?” And I said, “100 miles.” And you go, “oh my God, you’re at risk. You’ve driven 100 miles an hour.” And I said, “yes, but right now I’m sitting here, I’m not in a car, I’m not moving at all. I may have covered 100 miles in the 50 minutes before, but I’m not moving at all now.” Now, why do I say that? Effectively, over the last several months, inflation month over month has been zero. Zero. We were going quite fast. The headline says that over the last year, inflation has been 3.5%. But we’re not going very fast. Now, there was one indicator that showed inflation month over month two months ago was 3.5%.

If you annualize, 80% of that came from housing. And you and I both know, whether you look at REIT filings, whether you speak to people in the business, whether you own apartments that in that month apartment rents were going up somewhere between -2% and plus 2% with some outliers beyond that. That was to say that month was kind of a nothing, right? I don’t mean long term, I just mean that month. They had it at 8%, and you’re going like, oh, well, yeah, I guess if you mismeasure, you’ll get a number. So inflation is largely dead. Inflation was not created by the Fed. It was created by shut down supply, we shut down demand three and a half years ago. We shut down demand, we shut down supply, vast parts of the world, vast parts of the economy, restaurants went out of business, hotels went out of businesses went out of business, et cetera. Capacity was reduced, and demand came back faster than supply across the economy. So when demand came back faster than supply across the economy, what happened to prices across the economy? They rose. So, for example, it’s usually been called supply chain wasn’t supply chain per se. It was just shortages of supply because it took a while for supply to come back. Your desire to eat, to buy a hamburger at a restaurant, came back faster than the restaurant that closed came back all right. And therefore the restaurant that was open could get a higher price as those higher prices created profits, guess what happened? Lots of new supply came. As that new supply came, guess what happened to inflation? Disappeared. And so that’s where we’re at. Except the Fed has this bizarre view that we have an inflationary threat still and that they have something to do with it. They don’t have much to do with it. Interest rates don’t have much to do with inflation. If interest rates had a lot to do with inflation, how is it that for eight and a half years in the 2010, we had a zero short term interest rate, yet no runaway inflation. We had low inflation. If the interest rate really determined inflation, those eight and a half years, we’d have had 10%, 12%, 15% inflation. We didn’t. And there are a lot of reasons. So they’re fighting. I made the analogy to someone, I have torn meniscus, and they’re doing chemotherapy on it. It’s not making it any better, but it’s doing some collateral damage.

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Jilliene Helman:

Yeah. So when does the Fed wake up, right? I mean, what does that mean for the Fed? Cutting rates or at least halting additional rate increases? What’s your prediction there?

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Dr. Peter Linneman:

A year ago, the interest rate was at 4.75%. And I said and wrote that they should start cutting now. So they’re already a year behind. If inflation is 2%, I said zero the last month. But say that’s overshot. If it’s 2%, maybe the short-term rate should be 2.5%. They got a long way to go to get down. I have no idea what they’re looking at. I remember 50 years ago, last month, two months ago, I started my graduate work at the University of Chicago, and one of Milton Friedman’s first lectures was, the Fed is always late, they’re always arrogant, they always overreact. They believe that they’re driving a precision automobile with brand new wonderful tires on a test track in perfect weather conditions, when in fact, they’re driving a beat-up jalopy with bald tires on ice in a blizzard. So when you’re driving a jalopy with bald tires on ice with blizzard, do you have some control over the vehicle? Of course. Some. If you pretend like you have big control and you’re driving on a test track and you’re going and so you’re going to oversteer and you’re going to cause a lot of damage. Now, that was 50 years ago. It’s the DNA of the fed. It’s the DNA. I think of a lot of the people who get selected to be on the Fed. They’re not bad people. I mean, it’s not that. It’s that how would you react if I said, “Jilliene, tomorrow you’re God, you actually might come to believe it. And that kind of is what happens.”

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Jilliene Helman:

Yeah, but given that your earlier commentary greater than 50% of the economy is not sensitive to increases interest rates, do you believe that Fed policy can torpedo us into a recession?

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Dr. Peter Linneman:

They can hurt it through that 20%. There’s no doubt. I mean, you’ve seen apartment starts plummet, which is great news for apartment rents late 25, 26, 27. Right. Because apartment starts have plummeted. You’ve seen warehouse starts plummet. That’s a little drag on the economy. It’s not like it’s going to make the economy go negative, but there’s no doubt that’s a drag on the economy. Great news for warehouse rents in 25, 26, 27. Right. They believe a model which has never empirically been correct.

I point out the eight and a half years of zero interest rates. Wouldn’t you think if you had eight and a half years of zero interest rates and inflation didn’t act like you thought it would, you’d have some humility about changing interest rates. They don’t. They’re captured by a certain way of thinking. The people who get chosen for it are people who believe that there’s a high priest kind of dimension to it, for lack of a better phrase. As I say, don’t mistake that they’re evil, but by the same token, they’re not the best and brightest either. They’re not the dumbest and not the best. They tend to be pretty removed from reality. Certainly the staff members tend to be very removed. We were talking about, wouldn’t you think that if 80% of the increase inflation in one month was due to housing, somebody would have looked at, as you said, REIT filings, somebody would have called Greystar and said, “I don’t know what’s Greystar have 200,000 apartments they own and or manage?” Wouldn’t you think somebody would have at least picked up the phone and asked Greystar, “is it consistent with what you’re having?” They don’t.

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Jilliene Helman:

Is it actually what you’re seeing at the property level? Which it’s not. We’re in enough apartments to know that.

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Dr. Peter Linneman:

By the way, I’m not saying they should even call them every month. If what you found is what happened for housing was the same as everything else and it wasn’t very much, and it was like, 1% inflation like everything else. But if it’s going to be 80% of a number, common sense would just say, check it, right? And I don’t get it. I don’t get it. It’s not like these people wouldn’t answer, right? Anyway.

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Jilliene Helman:

Yeah. One of my life philosophies is do the work, right? Do the work. Pick up the phone, do the work. And it seems like there’s a big gap.

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Dr. Peter Linneman:

And by the way, you took economics classes. The people on the Zoom took it. Did you ever hear them talk about pick up the phone and ask if what you’re seeing in the data is consistent with what you’re living? And you never heard that, by the way, I did PhD. It’s not what people were trained to think. I’m trained to think it because of the other part of my life. You’re trained to think it because it’s part of your life. When you see something that’s at odds with what you otherwise believe, you’re trained to say “what’s going on?” right? It’s not at all what’s happening there. So, they’re going to be late. They’re going to do some damage. The chemotherapy to the torn meniscus is doing some damage needlessly. It’s not going to kill the patient. The patient is too healthy, but it’s certainly not helping them. They’re going to stop the chemotherapy because they’re also doing the meniscus largely will heal itself off over time. And if not, you do a little surgery and it’ll do it. So they’re going to be late, and until they’re late, there’s going to be some stress in the capital markets. One thing I didn’t mention is this is very different than the other times. I’m old. The other times were 73 to 76, 80 to 83, 90 to 94, 2001 to 2003, the financial crisis, late 2008 through about 2012. Very different. Why? In those other instances, both the capital markets and the rent and occupancy call it NOI were in trouble in all property categories. So the capital markets, there was no money flowing. And if no money flows to a capital-intensive business, it’s tough. And NOIs were down anywhere between 10% and 30 and 40% in those previous episodes. Right? Let’s go through what’s happening today. Okay. Money is tough. We can come back to that. But how are NOIs for apartments? They’re fine.

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Jilliene Helman:

They’re holding up or positive

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Dr. Peter Linneman:

There might be a little softness in the next few months in some markets because a lot of pipeline came on that got built up as COVID delayed happened. But they’ve shut down supply now. So 2025, 2026, 2027 will be good. Anything you don’t get next year, you’re going to get it back in 2026. Sort of in that sense. How about industrial? Industrial NOI, quite good. How about hotels? Quite good. How about good retail? Quite good. Office got challenges, right? So, office I’m not saying every property, I’m just saying office is more similar to those other episodes, namely, both the supply demand part has to have some adjustment, and the capital markets and the others, it’s just you need capital markets and money always comes back. The primary source of money is banks. Think of the following. I’m going to oversimplify this. One of the problems is banks are the primary source of capital for real estate, not just debt in general. Primary source. If they stop lending, it means you got to come up with a lot more equity, right? And that’s hard to find and puts a lot of challenges on. And the banks will tell you we don’t have any money to lend. Now, imagine you get one year of nominal growth, of GDP, of 5% nominal growth. Nominal is relevant here, that is, including inflation.

What do you think happens to bank deposits if GDP grows 5%? Bank deposits grow around 5%. Suddenly banks went from having no money to lend to “I’ve got 5%, I just now have money to lend.” By the way, if that goes on for 18 months, you have 8% of your total base of money to lend. And when you start thinking it that way, you see how the capital markets always heal. That growth ultimately heals capital markets because they start flowing, once you start lending, then I feel more comfortable lending. Once you lend, people feel more comfortable bidding. That reinflates property prices, et cetera. And in fact, one of the interesting things, Sam Zell was a very dear friend for 33 years, and Sam had this raspy voice. And Sam would always say, everybody always says they wish they would have the opportunities of 1973 to 75 and 80 to 83 and 90 to 94. And so he goes on and he says, you know what? The truth is, when they were available, nobody wanted them. Nobody wanted them. And that’s because it didn’t fit some nice little model and you had to do the nice little model, but you had to think beyond the model. And the thinking beyond the model is things equilibrate over time. And when they equilibrate, things do quite well. And I think people run the risk of missing great investment opportunities right now because they quote don’t quite pencil. If you’ve got a piece of real estate that doesn’t pencil because it’s not a good piece of real estate, don’t do it. But don’t do it when the capital markets are good. But if you’ve got a good piece of real estate and it’s going to operate well and you got a good operator and it doesn’t quite pencil because of current capital market disruptions, figure out a way to do it, raise a bit more equity, you’ll sort the capital market side of it out over time. Because my research and certainly somebody like Sam’s career says when things don’t pencil because of the capital markets, that’s when you want to be doing it right. But it is good deals, good real estate. Not if you want to sell it in a day, but if you’re going to hold it 5,8,10, 12 years, all these things balance out over time. And so I think actually this is a quite good opportunity, but you got to do it with more equity and equity can be hard to find. I mean, you’re in that business and it is a little what Sam said, which is, “everybody thinks they want the deals, but nobody wants them when they actually come because they don’t quote quite pencil.” But they do pencil. If capital markets are normal, and capital markets will be normal, but by the time you wait until capital markets are normal, your opportunity set is a little less attractive.

So research I did shows that if you invest in times when capital markets are in a bit of disarray, you’re going to do about 1% to 1.5% better return per annum over a seven- to-ten-year hold. Now, you can say 1%-1.5% is not a lot. That’s an unlevered number. By the way. That’s a 1%-1.5% unlevered. So, if you levered 50% times two, that’s a lot. What I found is, for example, apartments. Apartments on a ten-year hold, unlevered, no debt, tend to do 9.5% IRRs and you go, okay, if I can pick up 100 to 150 basis points, that’s a 10% to 15% increase in my return every year for ten years. I’ll sign up for that, right? So I think people need to have that in mind. One of the things is we all have these, I have a book you mentioned. I have this book that’s called the Blue Bible that tells people how to build those beautiful models and what to do. One of the first things you’ll see in that book is, understand, none of the numbers will ever come true. In other words, have that humility. And when you’re in times of disarray, the numbers are the best you can come up with, but know they’re never going to occur, and something probably more normal will occur, even though you don’t know quite how it’s going to get there. But normal has that tendency. You’ve been in a traffic jam. Traffic isn’t moving on the expressway. I’ll never get home. When’s the last time you never got home? Right. It equilibrates over time, even though the model at that time says, oh, at the rate we’re going, it’s going to take me 9 hours to get home. And then things equilibrated.

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Jilliene Helman:

What about within asset classes? So maybe we dig deep into some specific asset classes. You spoke a little bit about apartments, but let’s talk about office. I mean, office has been probably more disrupted than any other asset class. Maybe hospitality was pretty bad during the COVID times, but that’s had a nice recovery. But where do you see opportunities, if any, in Office? Where are the places in Office where you wouldn’t touch with a ten-foot pole? Are there contrarian plays? I mean, there’s a lot of cheap office right now. Is there office that people should be buying or how do you think about?

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Dr. Peter Linneman:

I think office, quality Office. I don’t care what’s going to happen, quality Office is going to be in demand. Rents will be whatever they’ll be. Sometimes they’re better, sometimes they’re worse, sometimes there’s more leasing, sometimes there’s less. But I know the better stuff will lease. If I were to do office, I would focus on the better stuff. I’ve been involved in office a long time. The better stuff goes through hard times. It then tends to come out and does quite well and doesn’t do as badly in bad times. The stuff I probably wouldn’t touch is it had 75% occupancy, the plan was get it to 90% occupancy and it’s subsequently gone to 4% occupancy. That’s tough, by the way. It’s just a run of the mill building. It’s nothing special, et cetera. That’s tough. And when I say good office, I don’t mean it has to be Nine West 57th. I mean, that’s obviously good office, but just good stuff, well located, well amenitized, landlord has the money to put into it for tenant improvements. They have the money to put in it to keep the building at a quality level, decently located, whether it’s city or suburban. But office is tough. Office has always been a tough sector. And I think that kind of commodity office has always been a very tough sector and will continue to be.

If you go to retail, good retail will do well. Good retail is doing well. Good retail is always hand to hand combat because you’re in the business of satisfying ever changing customer consumer, American consumer preferences. So 30 years ago, you didn’t want a gym. Today you want a gym. 40 years ago, you didn’t need somebody doing cataract surgery. Today the baby boom needs a lot of people doing cataract surgery. So the thing that makes retail viable is that if it’s well located, well designed, it will do well. But you’re going to constantly have to work hard at it because the preferences are going to change. Always has been, always will. If it’s bad retail, it’s got real problems. Industrial. Industrial, I like a lot. I’m going to oversimplify. Historically, warehouse, industrial, whatever you want to call it, if the economy grew 1%, we had 1% more that had to be shipped somewhere in the process, just roughly, whether it was for industrial purposes or consumer purposes. If the economy grew 1%, we needed about 1% more. Economy tended to grow 2.5%. We needed about 2.5% new supply, maybe a little more because some of it burned and some of it was obsolete and so forth. But you got the spirit. Then online sales occurred. And if you’ve ever been in warehouse that services online, much wider aisles, they have much more traffic happening inside the building, they have assembly areas, et cetera. So whereas it used to be if retail sales expanded about 1%, you needed about 1% more warehouse.

That’s still true if the sale is through a store. But if it’s through online, you need about 3 times the amount of space. So as online grows, so you’re probably up to a number like 1.4 to 1.5 times the economy grows. By 1%, you need like 1.4%, 1.5% more. That means for a 2.5% growth, you need something like 3.25% new supply. And generally we’re not bringing that much on and that’s why rents and occupancy are so strong and I think will continue for a while.

Apartments, apartments are good sector. I like them. I wrote a paper about 2.5, 3 years ago calling it the golden era of apartments. Partly because of the capital markets, partly because of fundamentals. The best thing multifamily has going for it is we have a massive shortage of single-family housing, like a 3.5% of total supply shortage. This is not like a 3.5% shortfall of bubble gum, in which case the price wouldn’t do much because you’d go to Spearmint Gum or Juicy Fruit or something, right? And it wouldn’t have a big price impact on bubble gum. If there was a 3.5% shortage of housing people want, and we know from looking at California and Tokyo and Paris, people will pay what they have to pay to get housing. And so went from no shortfall of housing in 2010 to 3.5% shortfall today. What do you think happened to housing prices over that? Not because of interest rates. And what happened was very odd Jilliene in that we way overproduced housing from 2002 to 2006. That was the housing bubble that created the financial crisis. And then we stopped producing homes. We were destroying more homes than we were producing for five years. Now, that’s important because NIMBYism and I’m going to be artificial because NIMBYism said, “okay, we’ll let you build 1.1 million homes a year, not more, but we’re going to let you build 1.1 million homes a year. You’re going to have to fight tooth and nail to build those 1.1 million homes, but we’re not going to let you build more than that, right? Not in my backyard. Okay?” And the builders turned around and said, “oh, never mind, I only want to build 400,000.” And the NIMBY people said, “Great, we’re happy with that. You’re happy with that?” And then what happened? The next year, they said, “we’re not going to let you do more than 1.1 million nationally.” And the home builders said, “oh, we only want to build 400,000.” And the NIMBY people said, “great.” They still made life miserable for the 400,000.

Well, you do that for five years or six years, and you suddenly have this big shortfall, like a three and a half million-unit shortfall. So now you say, “well, since we didn’t build them, then aren’t you going to let me build an extra 3 million this year?” And they go, “no, you didn’t seem to hear me. We’re only going to let you do a maximum of 1.1 million, and we’re going to make that very difficult.” And you say, “yeah, but we have a shortfall.” And they say, “I don’t care. That was your fault. That was your fault. If you wanted to build them, build them but I’m not going to let you do more than 1.1 million.” We’ve got built in a shortage of single family of three and a half million homes. What do you think that does to home prices? Makes them go up faster than inflation, makes them go up faster than income. What’s that do? To quote the attractiveness of renting, well, I need a bigger down payment for a home. That means I have to rent longer, and while I’m renting longer, or I rent a single-family residence. So single-family is the competition to multifamily. If single-family has a shortage, multifamily benefits. And that shortage isn’t going to go away in a hurry because NIMBY’s are not going to allow that gap to get closed. They’re just not, they’re not going to suddenly say, tomorrow, okay, build 2 million. They’re just not going to let that happen. So this gap stays. So single, multifamily, and there are other good things, but one of them is multifamily has built in a shortage of housing, then you add to it micro dynamics of how many young people and where they want to be and so forth and so on. So I like that. That’s a quick journey around the property. And then hospitality. Hospitality, pent-up demand. Pent-up demand of like, 9%. So you’re going to get next year all the normal demand you’d get in a normal year, plus some of that pent-up demand. So hospitality looks pretty good. Rent and occupancy.

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Jilliene Helman:

Talk to us a little bit about office to multifamily conversion. Peter, you’re involved in a deal on the RealtyMogul platform 300 6th Ave. And it doesn’t have to be that deal specifically, but just from a theoretical perspective, why does that make sense? Right? There’s a lot of office to multifamily conversion that makes no sense. We’ve looked at a lot on the RealtyMogul platform. We’ve turned down a lot. And there’s, I would say, a small subset that makes sense, obviously, because of the fundamentals of multifamily you just talked about, but maybe help us understand that thesis.

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Dr. Peter Linneman:

I am involved in several conversions, and I’ve said “no” to a bunch. All right, so let’s go through what you need. First of all, you need people who want to live there, right? People want to live there. Some office locations. Nobody wants to live there, right? Nobody would want to live there. That’s number one, because if nobody wants to live there, you’re not going to make it work. Second, is the building conducive to being residential? And when I say conducive, you can make anything conducive to residential. At what cost? All right, conducive to residential. Does it lay out without unbelievable amount of work? That’s 2nd. 3rd is, does it have lots and lots of tenants that are locked in for a long time? Like 40, 50, 60, 70% of the building? Because they’re going to go from not being happy to be there to the minute you say you’re going to convert, they’re very happy to be there and want you to buy them out. And that messes up the economics. The other dimension of it goes, look, when I buy a building, let’s just say you and I go out and we buy, well, the Pittsburgh building. It’s a good example. We buy the Pittsburgh building, what are we really buying? What we’re really buying is the land. What we’re really buying is the core concrete. What we’re really buying is the core steel. We’re buying the core electrical, the core kind of mechanical, if you will, and the labor associated with putting the concrete in, putting the steel in, et cetera. Okay, that’s what we’re buying. Question is real simple. Are you buying it at a good price or not? If I’m overpaying for land, forget it being a conversion. If I told you I’m overpaying for land, concrete, steel and the labor that went into putting it in, it’s going to be hard to make it work. If I can get it where when you look at steel prices and concrete prices and, by the way, in addition, when I buy it, I’ve locked in my cost on those items, whereas the typical development, I’m not going to know exactly what my steel costs are going to be for seven months and so forth. So sometimes it works. And if you can get historic tax credits and redevelopment tax credits and so forth, that bring it in, those are real specialty efforts. And so I don’t know what the math would be. I would guess one out of ten might have potential. I believe the one that you mentioned in Pittsburgh does. But time will tell. That’s a great example when you bring in the various tax credits, et cetera. Basically, the land, the concrete, the steel, the labor associated with putting in would cost zero. Now, does that guarantee success? No, but boy, it’s a good start if you can get your land, your basic steel, your basic concrete, et cetera. By the way, go to a ground up development. And if I came to you and I said, Jilliene, I can get my development and somebody’s going to give me the concrete, the steel, the labor associate for free, you’d say, I don’t know if it’s going to be a good development, but it’s got a good start. So that’s the way to think about it. You just have to be realistic about what you’re getting and kind of think it through.

•••••

Jilliene Helman:

Yeah. We have a couple of questions that have come in, Peter, so I’ll tackle a couple of these. One is opinion on build to rent. So I assume, given the dearth of available housing in markets, you’re supportive of build to rent. There needs to be housing, right? It sort of acts like multifamily, but any specific commentary on build to rent?

•••••

Dr. Peter Linneman:

Two comments. It plays quite well to people with families, right? In other words, if I don’t need a backyard and I don’t care about the school district, traditional multifamily probably is okay. But there are people who can’t come up with the down payment that have seen home prices run on them, and they’re not going to be able to be in there for several years. Essentially, what you’re doing as the build to rent is providing a down payment for them, but you’re demanding an equity return on it rather than a loan return on it. Now, the question I’ve had so it works, and the question is you got to put it where people want it to be. It’s got to be where people want to be. So if I’m building to rent in a location where people who want to rent homes don’t want to be it’s not going to work. So it goes back. Real estate 101. Do people want it? If they do, I think it’s a good product. I think it’s a good product.

•••••

Jilliene Helman:

Let’s talk about markets. I think it’s a good segue into markets like what markets are captivating your interest right now, what are the factors that are making you interested? And I think the primary factor is people want to be there, right? People want to be there, people want to live there. But what markets are you particularly excited about right now?

•••••

Dr. Peter Linneman:

Okay, I think the first thing just to set the stage is while I do look at what’s happening in a market quote right now on a real estate, it’s a long-term investment, right? I’m not going to trade it tomorrow. I’m not going to buy it today and trade it tomorrow. I’m probably going to hold it 7-10 years, maybe 5, but 7-10, 12-15 years. So yes, I look at what’s happening today, but I also look at what do I think happens over the next decade and in a way that’s much more important to me the next decade than the next six minutes. So where do I like? I like places that have shown the ability to roll with the punches and have sustained job growth. That tends to be sunbelt, right? And there’s a lot of reasons for it. New Orleans, even though it’s in the sunbelt, been a tough place for growth on a sustained basis.

•••••

Jilliene Helman:

Let alone trying to get an insurance quote in.

•••••

Dr. Peter Linneman:

I mean, it’s difficult, right? So Orlando, I like a place like Charleston. There are some very nice smaller markets. The challenge of a smaller market. I think I’m individually responsible for creating a huge excess pipeline in Huntsville, Alabama. And that’s because great market, demand wise. Great market, demand wise. I had a couple of clients come to me about five years ago and we did studies. I said, the demand is good, supply is good. And then they went there and they told all their friends how great it was. And now it’s a heavily oversupplied, not under demanded. Right. The demand is right where I thought it would be. It’s the supply just went and it’s small market, right? You’re not going to get this huge absorption of undelivered units. It’s hard not to like places like Charlotte, Raleigh, Nashville, you might argue where I like these areas that are rifled. I mean, we’re doing a project in Pittsburgh, as you know, we’re doing a project in Cincinnati, downtown. These are rifle shots though, right? Doesn’t mean they’re not great. But if I’m shooting with a shotgun, you’re going to go to these traditional markets. But Columbus, Ohio is a good market also. California has always just been hard for me to figure out. Portland’s hard for me to figure out. That’s probably more about me than them. You know, California’s got a lot of challenges.

•••••

Jilliene Helman:

How do you think about the supply and demand? Because when we think about a market like a Raleigh or a Charlote, I mean, there’s just so much supply coming online in those markets versus maybe a Midwestern market where you don’t have as much job creation or population growth, but you have much less supply. So that the balance of supply and demand is one of the things that we look at very closely.

•••••

Dr. Peter Linneman:

Yeah. There was a man, Alfred Marshall, who preceded Keynes at Oxford. His great insight was supply and demand both matter. And before that, there had been this discussion, it was all prices were about supply only or demand only. And he goes, no, it’s both. So you’re right, it is supply and demand. So, yes, you want a place with good demand. Supply can be a challenge in some markets. And it’s been the problem in the Texas markets that growth is 3% and the growth in supply is 4%, and that makes it great for the developer, but it’s a challenge for the owner. And parts of Atlanta are that way, and the Midwest markets and the more boutique markets are less. So that way you’re not going to have somebody come in. I’ll take Pittsburgh, you’re not going to have every developer in the country come build a new project in Pittsburgh. It’s just not big enough and it’s not sexy enough. And so, yep, demand is not as big, but I only need enough demand growth to fill the units that are there. So you’re right. We look at that. The ideal is to get a market where foreign capital doesn’t want to be when you’re buying, or institutional money. Better way of saying the dream come true is institutional money doesn’t want to be there when I’m buying, but they want to be there when I’m selling.

•••••

Jilliene Helman:

Columbus is probably a great example of that.

•••••

Dr. Peter Linneman:

Columbus. And by the way, you know, Charlotte was that way at one point. Even Nashville, frankly, Nashville was that way at one point. Austin was that way. 30 years ago, the notion that major institutions would want in Nashville or Austin was laughable. Laughable. I remember 1990 talking to people about Charlotte. It was laughable. So, I mean, yes, everybody would like to time those, but timing such things is hard. You have to kind of assume however popular the capital market is, when you go in more or less, it’s going to be that popular when you go out. I give you the product analogy. We’re talking about locations. The product analogy to Pittsburgh or something like that, is retail. The retail demand only grows kind of at the rate of the economy. It’s not going to go off the charts, but supply is going to grow almost not at all. And so that’s the beauty. We own an apartment project in kind of nowhere, Ohio, 210 units. And we’ve done very nicely on it. It’s not institutional, it’s not even close to institutional, but nobody’s ever going to build a project in that town of any scale. So we’ll be the best project in that town forever. And it fills and it rents. And it’s not because there is a little demand growth, a little bit, but not a lot. But there’s no supply growth. And we do pretty well. Now, finding a whole bunch of those is hard. Right. And getting investors interested because they go, “where is it?” It’s hard to do to scale. But it’s doable.

•••••

Jilliene Helman:

Yeah. We own a project in Orient, Michigan, which a lot of people go, “where is it?” And it’s one of our best performing asset because it’s supply.

•••••

Dr. Peter Linneman:

Yep. And I would bet it’s exactly the same as our New Philadelphia-Dover, Ohio project in that way. And we had a little catalyst because we knew there was a lot of infrastructure going in with fracking there. So there was a bit of demand but by the way, a bit right. Like we can rent 15 furnished units, not 500 units are needed. Because if 500 units were needed, somebody would come in and build a 250-unit project and somebody’d come in and build a 250-unit project, and suddenly my project would be the oldest, not the only. And so what you want is where there’s a little something, but you get stability. Some of these university towns can be quite good. It’s one of the things that attracted me to Pittsburgh is you have University of Pittsburgh and Carnegie there. Gives a lot of stability, some growth, lot of stability, and not big enough to attract the big sharks.

•••••

Jilliene Helman:

Peter, shifting gears, what do you think is going to happen in distress? We have a question here around, do you anticipate there to be distress, particularly in the multifamily industry? I mean, it feels like property operations are holding up, but what we’re seeing is that if there’s distress, it’s going to be capital stack distress, where they’ve got floating rate debt and interest rates have run. But what’s your perspective on distress in the multifamily industry?

•••••

Dr. Peter Linneman:

I think in the multifamily, you hit it if you did fixed rate financing, there’s not distress.

•••••

Jilliene Helman:

Right.

•••••

Dr. Peter Linneman:

You locked in two years ago, three years ago, you’re five years ago, your rents are unbelievably higher than you thought they would be. When you locked it in, the interest rate is reasonable. Even if you locked it in five years ago, you’re good. If you locked it in two years ago, it’s great. It’s not from that. It’s somebody who floated. If you floated, then there is some challenge on the multi. I’m not going to talk about development. That’s slightly different where you did float, but it’s not a project yet. But I’m going to use $100 million just because it’s easy to get the math, that’s all. You have a project that was worth $100,000,000. 2 years ago has the NOI. The NOI has not fallen. It’s actually gone up probably 5% from two years ago. So you had a building, a project that was 100 million, and NOI is up about 5% over the last two years. Okay, kind of sounds reasonable. You floated your debt and you had 70% debt. So you had 70 million of debt, and the money is costing you 4% more than you thought. That’s $2.8 million a year as long as the interest rate stays up. Now, you have to put that in context. Even if that lasted for two years before the Fed lowered the interest rate, it’s a $5.6 million dollar hit. But let’s just stay with the $2.8, call it $3 million dollars. Fair enough. Just for a number. You have a $3 million dollar shortfall project that was worth 100,000,00 2 years ago, and your income is up 5%. Are you going to sell it for a 20% haircut? Not a chance. Not a chance. For a $3 million dollar shortfall of income for one year, maybe even two years, you’re going to take a project that you had worth 100 million dollars.

We know history tends to say when capital markets are the source of price drops. Remember it was an NOI increase. Be very different if the NOI was down 10%? That’s not the case. It’s. The NOI is up. And you know from past history, when money comes back, pricing picks back up, right? So you’re not going to say, well, it was worth 100, I’m going to sell it for 80. That’s stupid. What you’re going to do is find a way to get the $2.8 million dollars. And by the way, you made a lot of money. Maybe you put it in, maybe you go out and borrow 3 million at 12%. All right, fine. That’s expensive money. It sees you over a year or two, but you’re not going to take a 20% haircut. So I talked to some of these buyers to say, well, I want a 20% discount on a stabilized apartment building, and they’re going to do it because they have floating rate debt. The math just doesn’t work. They’ll take maybe a $3 million haircut, maybe a $4 million haircut. But if you even think of that’s quite aggressive, given income is up 5%. So they’re going to find a way to Band Aid it. If it’s a development, it’s a bit harder because you don’t have in place income, right? So it’s a bit harder. You use floating rate debt, you’re getting squeezed. There are some people who did development that are being squeezed. They use floating rate debt. They can’t come up with other money, but most of them are finding money from their existing partners. They realize it’s temporary. By the way, the construction costs that they thought were going to go up 20%, only went up 5%. So they’ve got cushion in their construction budget to offset some of the interest rate. Lot of work, a lot of pain. But the notion that multifamily is just going to have this mass capitulation, I just don’t see it happening over the interest rates. And particularly if you believe the Fed reverses anytime in the next year or two because that number disappears, it is unrealistic to expect a 20% discount on a 3% shortfall.

•••••

Jilliene Helman:

Yeah, we’re coming up right on the hour here, Peter, so I’m going to end on a fun one, first and foremost. Thank you so much. This has been incredibly insightful, and I think that I’ve learned a lot, and hopefully our audience have learned a lot. But let’s end on a fun one, which is what advice would you give your 20-year-old self when it comes to real estate investing?

•••••

Dr. Peter Linneman:

Oh, I thought you were going to ask who’s going to win the Super Bowl? And the answer to that is easy. It’s the Eagles, right?

•••••

Jilliene Helman:

All right, I’ll give you two. The Eagles are going to win the Super Bowl.

•••••

Dr. Peter Linneman:

And no. What would I say to myself as 20 years old? Believe in yourself, work hard, which I did. I wish I’d have believed. There were days right. I generally believed in myself, and I generally worked hard. There were days, right, where you didn’t necessarily believe. There weren’t weeks or months in my life, but there were certainly days. No, I would say believe. I’d say work hard. I’d say associate with people smarter than you and not just in your field. All these Nobel Prize winners and great academics, I knew I learned tremendous amounts from them, but at the same time, I knew the Al Tallmans and Mort Zuckermans and the great people there. And I think I know I learned a lot from them. And part of the challenge was putting it all together. The other thing I would probably say is be curious. Be curious. Curiosity is a very undervalued asset, natural curiosity. If you’re hungry to keep learning things you don’t learn.

So I was talking to my charity today over in Kenya. We did a zoom for our students there, and I said, look, I went to university until I was 27. I think 26. And I learned a lot more in the 46 years after than I did the years I was in school. And I’m sure the same is true for you. It’s not like you didn’t learn a lot. I did. I learned a tremendous amount. But be curious and just keep learning. I knew nothing about adaptive reuse when I came out of graduate school. I mean, what if I limited myself to that knowledge base? So be curious. Be a believer, work hard, and be around people who know more than you do or at least know more about things, certain things than you do. Right. They may not know more about everything and just try to piece it all together. Life is a bit like a mosaic. You get all these little pieces of colored glass and you try to interpret how they all fit together. I guess the thing I’d end on is I just spoke to her, I have an amazing woman who will be 102 on New Year’s Eve. She was one of those women of that generation. She was on five corporate boards in the blah blah, raised a families, the only woman in her class at Northwestern MBA in 1946. So she was of that generation we’re losing and pretty amazing person. And I call her every day and I asked her about twelve years ago what’s it all about, which was sort of a 60-year-old me asking. And she gave the best answer I’ve ever heard. Which is the key is to love, be loved and be productive in everything you try to do. So I’d end on that as my holiday note as well as my real estate note. How about that?

•••••

Jilliene Helman:

Oh, I love it. Well, thank you so much for sharing your wisdom with us today, Peter. A big thank you to our audience for joining us. If you’re interested in learning more about Peter’s work, his website is linemanassociates.com. If you’re interested in learning more about RealtyMogul and what we do here, we’re at RealtyMogul.com and love and be loved. I love that feedback. And happy holidays to all. Thank you so much, Peter.

•••••

Dr. Peter Linneman:

Thank you.

•••••

Jilliene Helman:

Take care.

•••••

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