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Peter Linneman – 2023 Economic Outlook

We were honored to talk with Peter Linneman on our podcast about the multifamily 2023 economic outlook. Peter is the Founding Principal of Linneman Associates, LLC, a leading real estate advisory firm. For more than 40 years, he has advised leading corporations and served on over 20 public and private boards, including serving as Chairman of Rockefeller Center Properties, where he led the successful restructuring and sale of Rockefeller Center in the mid-1990s.  He has published over 100 scholarly articles, eight editions of the acclaimed book, Real Estate Financial Investments: Risks and Opportunities, and the widely read, Lindemann Letter quarterly report. He is also the co-creator of the popular and highly regarded Real Estate Finance and Investment Certification course. Most recently, he co-authored the best-selling book, The Great Age Reboot: Cracking the Longevity Code for a Younger Tomorrow.

What is Peter’s take on the Current Market Conditions?

Multifamily is a combination of how’s NOI doing, and how does the capital market view that NOI? How hungry is the capital market for that NOI? Currently or starting about August, late August into September, the capital market said we aren’t interested in anything. There was a lender strike, banks in particular, as the primary source of capital said to everybody not just real estate, “No. We don’t want to lend. We’re only going to lend to those willing to pay big spreads at higher interest rates.

The reason was because the Fed told them they were going to keep interest rates low for a good while. They had a very active first two thirds of the year at the major banks. They had a lot of loans in warehouse to be syndicated and securitized. The rates rose very quickly. The Fed said, “Oops, we were only kidding.” Their loans were sitting at losses. So instead of being able to keep spinning that money and make another round of loans before year end, they sat on it, because they didn’t want to sell it at losses. Nobody likes selling at losses. They could afford to sell at losses. It wasn’t like 1990 for the SNLs or in 2009 where if they sold at losses, they were out of business. They have enough capital, the Fed has given them stunning amounts of capital and will give them more if they need it. So they can afford to sell it in the sense they don’t go out of business, but they could not afford to sell it in the late months of 2022, because it would have wiped out the bonuses.

Peter adds, “I don’t know about you, but I want my bonus and I can go on a lender strike for – I can’t go on a lender strike forever, but I can go on a lender strike for two months, three months, four months, five months, because I know I have the money to sell them eventually at a loss once my bonus is paid. Year end, 2020 ended, they didn’t get stunning bonuses, but they’ll do okay, because the first eight months were highly productive. They sat on their hands. When they sat on their hands, most equity sat on their hands, the non-bank banks depend on banks for their money so they largely sat on their hands. So that’s why I focus on the banks is the crystallizer.

Now, I can tell you, as somebody who’s been on a lot of boards. I’m not on the bank board, but I’m on other company boards and right now we’re establishing budgets. As soon as we establish budgets, the Comp Committee establishes compensation goals for the year. The banks need to sell those loans and they can afford to sell those loans. They need to sell them to recycle the money and get origination fees and syndication fees. When are they going to sell them? As soon as the budget locks in that they can sell them this year and still get bonuses.

Of course, the budget is going to say that, because otherwise they won’t be able to make loans. By the end of this month, very early next month, the banks will have compensation targets locked in that will allow them to sell loans at losses. That means the remainder of the first quarter and into the second quarter, you’ll start seeing banks sell their loans. As they do, they’ll lend. As they lend, that’ll happen with a lag. As they lend, spreads will come down. As they lend equity will come back, because it’s sitting on the sidelines. As it does, cap rates, all my research shows cap rates aren’t determined by interest rates they are determined by capital flow. So the cap rates that gap when money stopped flowing will reduce a bit and you’ll see the capital market valuing NOI, not terribly dissimilar to 2018 2019. Let’s say most of 2022 or the first eight months of 2022.

The capital market, I think, by the second half of this year, because you can see how what I described on the capital market is not an overnight. There are steps. You got to get me a budget. I’ve got to then sell it. Once I sell it, I got to develop a book of business, I got to close the book of business. It’s going to take a little while but by the second half, capital will be flowing and capital markets will look very different than the last few months. Another way of saying it, greed will replace fear. Greed always replaces fear at some point. Fear or sitting on the lender strike predominating more or less the first half and the return of greed and active lenders in the second half. Then receding cap rates.

Then you go to the NOI side, button occupancy. As you know, you’ve seen a big drop. That’s because projects don’t pencil at higher interest rates on the float side. Construction costs are up and not only your construction costs up, projected construction costs are even higher.  Let me put it in the context of oil, just for an example. Oil went from 60 to 125 in a matter of two months. So not only were they saying I’ve got to be covered at 125. I got to be covered at 150 or 170 if I’m going to do a guaranteed contract. So those guarantees come back.  Oil’s back down to 80. That starts working its way through. The lumber, lumber was in 1800 is back down to  380 or whatever number it’s at. So it takes a while.

Supply is going to be dropping in the first quarter of this year. Not good for developers, good for owners, right? I mean, when people ask how’s multifamily going to do. Are you a developer or an owner? I’m happy when developers are unhappy if I’m an owner. That’s the tradeoff. I think you’re going to see the first quarter starts are going to continue to go down, probably flattened out late in the second quarter, and then start rising in the third and fourth as people who delayed projects do them. The interest rate is up. You don’t have equity. You can’t get the loan, etc.

I think on the supply side, NOI looks good. On the demand side, it’s good. The reason I say it’s good is, we have a fundamental shortfall of housing, because nimbyism. Nimbyism is probably created a three and a half percent shortfall in the supply of single-family homes. People have to live somewhere. In some markets, it’s created a shortfall or sub markets have created a shortfall in multi. I want to be in a market where there’s a shortfall, right, as an investor. Not every day, but most days turn out pretty good for you. Money will return. We have no inflation right now. We literally have no inflation. November, December data clearly showed no inflation in the US economy.

You say, “But it said year over year, it was five and a half percent.” I don’t care about year over year. I care about now. What you saw in November was no increase from the prices of October. None. You saw in December, if anything they were down a little bit and you’re going to see in January, they’re down a little bit. So we have no inflation in the economy. Now, that’s not to say all prices are falling. It’s just to say, if you have zero inflation, half the prices are up, and half the prices are down. Few of them are up a lot. A few of them are down a lot, and it averages it out. So we have mild deflation as we’re sitting here.

At some point, even the Fed will notice that. At some point, the Fed will say, “We don’t need to keep raising rates. In fact, we’ve got to reduce rates.” They’re going to be too late reducing rates just like they were too late raising rates, but they’re going to reduce them. By the way, they’re going to raise it one more time. Why? I don’t know, but you’re younger. I went to Catholic school back in the day, ask your parents or grandparents. When they punish a kid, you’d say, “Well, why did you do it 11 times?” One was for good measure, right? You’re like, “Well, the kid didn’t need one more whack. I don’t even know they needed 10, much more 11.” That’s the Fed. They’re going to do one more for good measure. They didn’t need to do as much as they did. If inflation is zero, do you really need a 5% interest rate? I don’t think so. You might want a 3% or 2% interest rate. If inflation zero you have a long discussion.

Demand is in good shape. Essentially, what you have on the demand side is a war going on between the consumer in general and the Fed and also regulation. But let’s just focus on the consumer. The consumer typical is your age. You bought your house seven years ago, the typical consumer. I’m not talking about the renter for a moment. Typical consumer is your age. You bought your house seven years ago or eight years ago. You locked in a 2% or lower mortgage before the beginning of 2022 for 30 years. It’s like, sign me up. You have two job openings for every person looking for a job. Your wages have outstripped inflation and over the last three years, and your wealth has outstripped inflation by 7% over the last three years.

Now, you were happier when it outstripped it by 20, but I’m not so unhappy that it’s 3%. I mean, 7% higher, that’s the net of inflation. The consumer is going, “Yeah, I’m in pretty good shape.” We’re creating jobs, unemployment claims came out yesterday really low. You know we’re going to get really good jobs data this month etc. etc. So the consumer is doing pretty well. Meanwhile, the Fed is saying, “We got to get 2 million people unemployed.”

By the way, every one of those people is generating about 70,000 of GDP. GDP is still below trend. Now, if you’re still below trend and you still don’t have people back to work the way they should be back to work, why are you trying to create unemployment? We’ve added 4.7 million people since the beginning of the pandemic, and we’ve only had 1.2 million jobs. Okay. Imagine a country that only had 1.2 million workers for 4.7 million population. You say, “We need a million and a half or a million workers.” We don’t need a million fewer, that would be an economy of 4.7 million people with no workers. That would be absurd. Even in Europe, that would be absurd. You go, “I don’t know what the Fed is thinking. It’s really crazy.” And you have to believe sooner or later, they’ll see the light and they’ll surrender and do the right thing, but in the meantime, there’s a real battle. By the way, just as a add on, when the Fed announces that they’ve laid off 2% of their employees, at least I can work up a rooting interest in them trying to get rid of a whole bunch of employees in the rest of the economy.

Why is Construction Projecting Higher in the Future when we’re Getting Inflation that is Flat right Now?

“The cost is real simple. Interest costs are going to come down by the second half of the year. You’ve already seen product, eight 10 months ago, you can not only couldn’t get product, if you found it, it was really expensive. Materials, today, you don’t hear people complaining about not being able to find materials, and at least it’s as much cheaper as is more expensive. Longer being an extraordinary example now like aluminum is up, so it depends, but for example China opening up will help supply of a lot of products. Some of those are building supply related, as opposed to when they were locking up every other day in some city, right?

I just see supplies coming back, suppliers come back. That’s why inflation is down, not just in construction. I see construction costs probably moderating and by the end of the year, they’re going to be lower than today, I believe. The only wildcard is labor, right? The only wildcard is labor. That’s a real part of construction costs. I’m not trying to suggest it isn’t. Why do we have high labor costs? It’s because we’ve discouraged people from working. I mean, with various policies. All well intended policies. There’s no malevolence in these policies. We were paying people more not to be employed than be employed for better part of a year and a half.

We have told people, think of somebody 28 years old, we’ve told him for three years, “You don’t have to pay your student loan.” You don’t think that discourages them from working. I mean, if we told him you have to pay your student loan, it has to make them a bit more incentivized to work. Now, and not everybody’s going to stop working on that. All these policies are at the margin. They’re all at the margin. We need more people working. I think you’ll see a moderation as materials come down. Just don’t forget how much lumber came down, how fast lumber came down.

Imagine that happened to every material from its peak, right? That’s going to be a dramatic and then you’ve got labor still going up. On the single-family side, so I’ll give you what my numbers are. On the multi side, we’re about a half a million short, on a national level, about a half a million shortfall of true supply demand balance. That’s on 44 million units, right? So half a percent some number like that. Not huge, but in some markets, it is big. Sub-sub markets, it’s big. Others it’s not. When you have a shortfall for something people really want or need, that’s when you see rents run. That’s when you see prices run. You don’t need a big shortfall in something that people really want. For bubble gum, you need a big shortfall to make the price run, but for housing, you don’t need a big shortfall for the price to run. They’re going to pay what they have to pay.

On the single family side, I’m doing from memory, my numbers around 3.5 million shortfall on about 90 million units, 93 million units to give an order of magnitude and you go, “Okay, let’s just call it a three, three and a half percent shortfall.” Three, three and a half percent shortfall for something people want. And remember, when we have a shortfall in its competitor renting, you see prices go up. Now they’re not going up currently, but that’s the lenders strike that’s causing that. There’s fundamental demand, supply imbalance, but there’s a lender strike making it difficult, but it can’t make it difficult forever. When you say, can I get numbers as high as four and a half percent, reasonably? Yes. I can get numbers as low as maybe two and a half million, but not lower than that. My best estimate comes out to around three and a half million on the single-family side.

By the way, one other point, the big surge in demand for multifamily. The one that appeared out of nowhere and got everybody near double-digit increases in many cases, real double-digit increases. It’s important to understand what it was driven by. It took me a while to figure it out. I think the data supports it. Prior to COVID, there were a lot of people that had roommates, including their parents, right? As their roommate, they were living at home. They had jobs. It was okay to live at home, because they worked all day and partied all night. So they didn’t have to deal with their roommates. They didn’t have to deal with the inconvenient living situation, if you will.

Think of people who had three roommates in Brooklyn, right? They didn’t have to deal, or Venice Beach, they didn’t have to deal that it’s 1,000-foot apartment with four roommates, because they worked all day and partied all night. Then what happened during COVID was, either they lost their jobs, so they weren’t working all day or if they were working, they were a lot of them were working at home all day. That was a disaster, because everybody was there. You can imagine parents and you can imagine arm’s length roommates like I’m talking about. They couldn’t party all night, right? There was no way you could party. So a whole bunch of people, I estimate about a million.

Now remember, million is about 2% of the entire multifamily housing stock. About a million of them decided between about December 2020 and about February of 2022, “I got to get out of here.” Whether it was the parent who decided it, or the kid, or the parents subsidized it. There’s a lot of ways. You had a surge of about a million who left roommates and moved in, but that’s over. That was on top of the normal multi demand growth, right? You have the normal multi demand growth that occurs in any year, plus this turbo charge. I don’t think the turbo charge so much goes away, because once they’re on their own apartments in a bad economy, they’re going to stay on their own. But that is a vulnerability. If you did get an economic downturn, you could get a surge the other way, because these people have had roommates that way, but I think don’t expect it to happen again. You’re back to normal multifamily demand now.

That wall {occupancy dropping}, I think, is a return to normalcy. When I say normal all I mean, is normal multifamily growth. How many kids graduated high school, how many graduated college, how many came out of the military? You name it. Versus how many gotten married and they wanted to buy a home or etc.? That normal demand. The reason it hit a wall is if you have normal multifamily demand and there’s no inflation, how much would you expect rents to go up? There’s no inflation.

A little bit. What’s a little bit? One, 2% over a year? Maybe. Well, as inflation ended, so did the ability to push rents, because you don’t have the fundamentals there to push rents. You were pushing rents, you were saying, “Great, we’re pushing rents by 8%.” I’d say “Yes, but inflation was seven, six and a half.” God bless, you were able to push it by 8%, but pushing rent by 8% and the world is 7%, inflation is indistinguishable from pushing rents by 1% in a world of zero inflation or zero in a world of minus 1%. If it’s 1% to zero on an annual basis that means on a monthly or quarterly basis, it’s rounding air. That’s what I think is going on

 When does Peter Predict the Fed will Lower Rates?

If I have to pick, this is hard, because the Fed is always late and they always overreact, and we’ve seen this again. Now to be fair to the Fed, they were not late in March 2020, they acted fast, they acted vigorously. So I can’t say they always, that was” we don’t know what’s going to happen, make sure there’s liquidity, let’s do it”. They were very late, because it was clear or pretty clear by November, December 2020, we had survived. We don’t need zero rates. We should be moving the rate up 25 basis points every two months, something like that, so everybody can adjust nicely.

They didn’t. They basically said that we’re going to do the same thing as they did in the 2010s, which was ridiculous. Keeping it at zero, literally zero for eight years, made no sense. So they’re going to be late. They should cut the rate this next time. They won’t, but they should. They probably should reduce it down to three and a half or three, but they’re not. Therefore – it’s hard to – I don’t know about you, but I think most humans find it hard to admit they’re wrong and are slow to admit they’re wrong. I certainly am. Fortunately, I’m never wrong. Though, my wife of 50 years would disagree.

No, but therefore I think probably by May, they’re going to be saying they’re going to claim credit for stopping inflation. They had almost nothing to do with it. It was all about supply coming back. There’s no way monetary policy could have acted fast enough to create the zero inflation of the last three months, because interest rates weren’t high. Monetary policy takes six to 18 months. The interest rate wasn’t that high in July yet. In August, it wasn’t that high yet. Didn’t get really high until the last two 75 BP increases, that’s when it really pushed it. That’s the problem is those are out there as dampening factor six to 18 months out.

If I had to predict May, something like that. They do a 25 basis point cut by then it should have been down to 3% my guess, but they’re going to go more slowly. They’re slow, almost always. They overreact. It’s a little hard, because what you’re trying to predict is a history of irrational slowness, and irrational overreact. Predicting irrational is always very – it’s hard enough to predict the rational. That’s one of the problems. I don’t know if you have kids, but the one of the hardest things that dealing with kids is, it’s hard enough to predict what a human will do, but one whose brains not fully functioning yet. It’s really hard, right? I’m not saying the Fed is not got a brain function, but in some institution that has that built into it.

We’re going to get down. We could get some substantial negative inflation, because of all like, think of lumber, right? Just across the economy. Think of oil across the economy. We could get some, I think more likely, as we’ll bounce around the first quarter or so of zero to a bit negative, which would make it like six months of zero to negative. I think we end up then at once you find those new lows. You’ve got a new low – It’s like we can’t just keep losing all your weight. Somebody says, “I went from 300 to 250.” Well done. Maybe from 250 to 200, maybe even 200 to 150, but you can’t keep doing that, right? Therefore, you could just see a normalization. I think it normalizes back to where we were, hopefully by the year end. Could be in the next year and around two, one and a half, one to 2% inflation in which case, I’ve always thought the short rate probably should be 50 to 100 basis points above current inflation and the long term generally 100 to 200 basis points above that.”

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