Overview of Walker Webcast with Dr. Peter Linneman
The following is an overview of the April 6th, 2022, Walker Webcast featuring Dr. Peter Linneman. We have tried our best to capture the insights shared on this webcast accurately but suggest you view the recap.
“Don’t bet against the US economy.”
At any point, it is possible to come up with a handful of difficult things that are going on in this country and in the world that affect the economy negatively. Right now, there is a divided congress, war in the Ukraine, inflation, rising interest rates, recovery from the pandemic, etc. AND YET (this is the key phrase), the economy carries forward… it prevails.
If someone had told you in February 2020 that there was going to be a worldwide pandemic shutting down major parts of the economy and causing over 6 million deaths, what would you have thought was going to happen to US economy? AND YET… real GDP is 3.5% higher than it was in 2020, employment is down only 1%, industrial output is down only 1% and consumer balance sheets are in good shape. (This doesn’t mean that every day and everything is great, but it was not the complete disaster that one would have expected.)
Rising Interest Rates: Raising interest rates (adjustments) cause pain… but the pain is not the same for everyone. Highly leveraged borrowers with mismatched investments (long assets with short liabilities) will feel more pain than the typical corporations that aren’t as sensitive to short term adjustments. Developers will feel more pain with short term adjustments, but lenders and savers will benefit from higher interest rates. Anything other than free money is going to feel a bit painful, but we can’t expect to get free money forever. Dr. Linneman says that, hopefully, a year from now, will be back to the 2019 interest rate environment.
Dr. Linneman and Walker discuss research by Deutsche Bank, which focuses on 13 federal tightening cycles starting in 1955. The study looks at the correlation between the first interest rate hikes to when a recession begins and they found that, on average, a recession will follow in 3 to 3.5 years. This would put a recession beginning around the summer of 2025. Dr. Linneman comments on how there is a lot of growth and profitability to be capitalized on between now and then, especially considering we have undergrown over the past two years (normally real GDP growth should have been about 5.5%). We have both the potential to catch up in addition to normal growth to look forward to.
Recovery: Dr. Linneman says that the “Butterfly Recovery” is over (starts, stops, floating up and down etc.). He predicts that real GDP growth in 2022 will be 3.5%, another 3.5% in 2023 and 2.5% in 2024. Growth will be driven forward by pent up demand in the economy and capital. The wild cards to be aware of are another devastating COVID variant and wage / price controls. Dr. Linneman believes that the biggest threat to the economy are wage and price controls. For example, he references what happened in the 1970s when Nixon implemented wage and price controls and the difficulty that ensued.
The Fed’s Challenge: Today’s inflation isn’t due to booming GDP, it’s due to lagging supply and supply chain issues. Raising interest rates is supposed to help cool off an over-heated economy but, if the real issue is with supply and the supply chain, there is the danger of pushing the economy over the edge and into a recession. The federal government is under extraordinary political pressure to do SOMETHING. Raising interest rates helps to better allocate resources. Dr. Linneman says that we are better off with inflation than we would be if GDP was down… that he wouldn’t give up 1% of GDP growth for normalized inflation. Inflation can be damaging, but right now this inflation is sending up signals saying, “bring capacity here, where prices are skyrocketing.”
Oil Prices: Two years ago oil was cheap! It cost more money per barrel for extraction than companies could make on a barrel sold. As a result, capacity got shut down, planned capacity got shut down, production and exploration got shut down. Now that demand is back up, supply is down, so prices are way up. The imbalance can’t be corrected overnight. Dr. Linneman also says that environmental regulations, the new green policy, have aggravated the imbalance between supply and demand and that these regulations are essentially rushed (we will need environmental regulation at some point but not right at this moment). Now, and for the next 5 years, we are going to get more energy mostly the way that we have gotten it – natural gas.
Labor and Wages: It makes sense that wages are up because even though employment is only down 1%, we have also had population growth, creating a whole group of people putting pressure on the job markets. Walker asked Linneman what affect unions (like the Amazon union involving 1.6 million people) will have on wages. Dr. Linneman discusses unions in the 70’s vs. unions today. In the 70’s, 35% of the economy was unionized and they had multi-year contracts. This created rigidity. Today, only 8.5% of the economy is unionized and multiyear contracts in the private sector are rare. As a result, there isn’t the same kind of rigidity that there was in 70’s.
Also, concerning labor, they discussed the possible effect of the upcoming baseball season on conditions in the urban cores. Many metros are still crowed with homelessness, drug use and crime. A great defense against crime are large groups of peaceable people. Baseball games attract approximately 25,000 people per night and with 82 games per year per city, this could help to ward off some of the crime that has proliferated with the absence of people visiting the urban cores as well as help bring back retail and office.
Industry specific: Watch out for speculative real estate development, primarily in industrial. Multifamily development is rebounding but it is still tampered by high construction cost. Construction of hotels has slowed and there is not much construction in office (office projects are being finished but not many new projects are being started).
Dr. Linneman notes that when considering investment, one must consider what is relative in terms of demand and supply. Developers want to go where there is demand growth because they are in the business of servicing growth. Hold investors want to go where there is both demand and supply growth.
Looking at multifamily, the nation is currently at 54.2% affordability for being able to purchase a new or used home (put in perspective, the long-term average is 62% affordability, and the peak in 2012 was 79% affordability). This “gives legs” to multifamily. The golden era for multifamily was strong for about 15 months and it still is somewhat, but some of the value in this sector has been mined. Also, affordability of housing is not the same around the nation. If you removed statistics from places like CA, OR, WA, eastern NY, Boston and D.C., the nation’s affordability starts to look better. It also might be important to note that some of these places are also where rent controls have been put into effect.
Also pertaining to multifamily, there has been about $15 billion in student loan debt forgiven in 5 rounds under the Biden administration. Further forgiving student loan debt may potentially free up the money for a lot of younger people to make a down payment on a house. Also, the federal government doesn’t seem to care to collect it. Most of these loans were guaranteed by parents and grandparents and that is a large demographic of voters to potentially make angry over collecting on this debt.
Walker asked Dr. Linneman if his tune has changed on retail since hearing about European owned Unibail-Rodamco-Westfield wanting to unload most of its U.S. properties by the end of 2023. Four years ago, they bought the portfolio, including some of the country’s top-performing malls, out bidding David Simon of Simon Property Group. Dr. Linneman replied that he still believes good retail is good and that Westfield overpaid for the portfolio in the first place. Also says that you “can’t buy bad retail cheap enough to make it work… because you can’t cut rents low enough to affect the price of cheerios and change people’s spending patterns.”
In a similar scenario Blackstone threw back the keys on their 1740 Broadway office building. It’s not that everyone should give up on office, it’s that they paid too much for it in the first place. Someone will buy this building at a better price and make it work. We needed a basis reset, to get rid of the excess– that is one thing the pandemic and shutting down 30-40% of the economy did for us. However, we need to remember that we are at the beginning of the reset, not the end. Things will take some time to normalize.