Dr. Peter Linneman joins Terry Montesi to continue the second half of their discussion about the current state of the country’s economy, and its influence on the real estate sector. Peter gives a comprehensive overview of the residential real estate economy and explains how the multifamily and single-family markets are simultaneously finding success. They evaluate COVID’s hard reset of the economy, its lasting impact, and the progression of our current economic cycle. Peter also depicts the cause-and-effect of the economic decisions made over the past year and a half, and how those choices can be seen in today’s real estate market.
Leaning In is published every second and fourth Wednesday of the month. Be sure to follow the show on your preferred podcast app to hear our next episode with Placer.AI’s Ethan Chernofsky.
Terry Montesi: On today’s episode, I’m back with my friend, Dr. Linneman, Principal of Linneman Associates, to finish our conversation on the changing economy and current real estate trends. We discuss real estate’s role in the cycle and what we can expect to see in the job market and the economy moving forward. He also shares his wisdom as we advance into mixed-use redevelopment and multifamily and his predictions for the future of retail, multi-family, office, and mixed-use.
Let’s talk about multifamily. Since we last talked, I think we told you we were entering the multifamily business. We’ve now hired development talent, and we are in the multi-family business. Tell me your thoughts, impacts of COVID and coming out of COVID, how you are feeling about the multifamily business and then commentary on the white-hot single-family market across this country, if you think that’s going to sustain and how it impacts the multi-family business.
Peter Linneman: So, let’s start off with the big picture. I get this question of how can multi-family succeed if its competitor single-family is also succeeding? And the answer is simple by the way. How can Ford succeed when Toyota’s succeeding? In other words, are you surprised that Ford has a good year the same year that Volkswagen or Toyota has a good year? No surprise because it’s reflective of the whole segment. And yes, Toyota might do a little better than Ford or vice versa. So, it’s not anomalous that competitors do well at the same time. That’s the first thing that’s important to bear in mind. Second is, in that regard, over the last 20 years, we have underproduced single-family housing by probably 4 million units. That’s like almost three and a half percent of the stock of single-family housing. And we have underproduced multifamily. Now, this is at a national level. And we’ve under produced multifamily by probably a half a million, which is a percent and a half. So, what we’ve got in the housing sector, more so in single than multi, is a fundamental underproduction of housing. And that’s a long conversation of is it nimbyism? Is it the lack of credit available? There’s a whole lot of discussion you could have, but that’s a fact.
Montesi: Builder capacity, etc.
Linneman: All that stuff. But this is over 20 years, and therefore, both sectors generally are set up with the tailwind of underproduction feeding a bit of excess demand. I don’t want to say crazy excess, but a bit of excess demand, which is home prices are going to exceed inflation, rents are going to exceed inflation just on those fundamentals, not in every submarket. Just because the average is under underbuilt doesn’t mean there isn’t a market that was overbuilt, but in general. So that’s the second thing. So, I think looking forward, multi looks good because it’s been underproduced. Then the demographics, the demographics of prime renters is pretty good. It’s not like after, remember after the Baby Boom, there was a Baby Bust; there was a big drop in the demographics. What has happened this time – you can see it in births; it’s not a hard thing to see – what you have is we hit a peak, and it’s often very, very, very slightly, and it’s kind of flat at a pretty high level for a number of years still. So, the fundamental flow is good. It’s not like we have this big drop off that’s going to happen again. So, I feel good about it that way. And by the way, in the short, short term, there’s good news and bad news, then I’ll come to the single-family side. In the short, short term, the good news is a lot of stuff didn’t get started in 2020 in the multifamily world, either because of freezes – regulatory, you couldn’t build – or because construction lending dried up until late in the year last year. So that has made the current rental market quite good in most locations, even New York, Brooklyn, they bottomed. Looks like in February, they bounced back, not all the way, but they’re coming back. And as you know, better markets have done quite well in the last, what, five months, something like that. And that’s because of the underproduction. That’s the good short term that will continue. The bad short term is that everybody in March, April, May, June last year in the building supply industry, and in a number of other industries – and I did the same thing you and I did, which is say stop, stop, stop, hoard cash, reduce capacity, don’t do, don’t do. Now, what that meant was that there were sudden drops in capacity in lots of sectors, including lumber and including many other products where capacity fell anywhere from 5% to 40%. So, if I told you capacity fell by 5% to 40% overnight, March, April, May, just instantly, and demand has largely recovered, what do you think is going to happen to prices? It’s not about monetary policy. It’s about capacity.
Montesi: Up in the short term?
Linneman: In the short term. So, you get this skyrocketing double, triple. Well, you don’t normally get doubling and tripling of prices historically. And when it does occur, they generally reverse themselves because economics kind of works. You get a doubling and tripling of the price, you give me a little time and capacity is going to come back online. Now it could take 4 to 24 months for that to run its course. In the meantime, a lot of projects, especially for merchant builders, don’t pencil. And again, that’s good in the near term for an existing party. If you’re not a merchant builder, if you’re a long-term build and hold, I don’t think the increase in construction cost is such a horrible thing, because if you’re going to hold 20 years, the fact that construction costs were, what, 10%, 15% high, when you did it, over 20 years, that’s a half a percent a year. The project’s not going to succeed or fail because of that; it’s going to succeed or fail on other things. On the other hand, if you’re a merchant builder where you’re just going to build and flip, that is choking. So that’s going to limit supply in the near term and make it good for existing multifamily and make it good for long-term capital on the development side. Now let’s come to the single-family. One of the worst predictions I ever made was in March of 2020, I said single-family would get crushed, just get crushed. And my theory was very simple. It’s always very cyclical – when the economy catches a cold, it catches the flu, and the economy had caught COVID. So, you can imagine what I thought single-family was going to have happen to it. No jobs, no confidence, no money for down payments, single family would dry up. And as you know, it did for about three months and then roared back. Here’s what I missed, two factors. My research going back to 1990 and everybody who’s ever done it since, the number one thing that stops people who can afford the monthly from buying a home is the down payment. I got to pay a monthly somewhere. It’s the down payment. And if I don’t have the down payment, I can’t buy. No matter how low the interest rate is, I can’t buy. So, here’s what happened. You had people who said nope, I’m not going to change my lifestyle. I’m making $100,000 a year. I’m saving $7,000 a year. Of the $7,000, $4,000 is my 401k. So, I only have $3,000 a year discretionary savings –that takes me ten years to get $30,000 down payment. Just bear that in mind. Now, here’s what happened. The savings rate went from $7,000 on a hundred to $33,000 on a hundred. How? The main way, it was your vacation to France got canceled. Your tickets for the Sixers got canceled. You didn’t go out to eat at restaurants. You didn’t buy the new dress, etc., etc. And suddenly, in 12 months, you saved about $30,000, of which only $4,000 was your 401k. So, you saved $26,000. Well, if what you need is a $30,000 down payment, you already had $3,000 of that from the year before. You had money for a down payment, and people flooded in because of involuntary savings. Then there was one other factor. There have been about 150,000 people 70 years and older, so let’s call them grandma, about 150,000 grandparents, if you will, died a notable number of years before they would have otherwise. Some died, but they were going to die in the next two months anyway so I’m taking them out. About 150,000 died from COVID notably sooner than they would have otherwise. Why is that important? Just back of the envelope, a third of that 150,000 had no inheritance to give. They just never did, never will, nothing to give to their heirs to speak of, maybe a $1,000 or $2,000, but nothing notable. A third when they died, left it to their spouse. Okay so, nothing to inherit to the- But 50,000, about a third, died and left an inheritance of $300,000, $400,000, $500,000. We’re not talking about billionaires here, we’re talking about somebody who owned a home, you sell the home, they had a 401k, they had a few CDs – we’re not talking rich, rich. They died and left $300,000 to be split among their two kids and four grandkids. That’s $50,000, that six times $50,000, 300,000 people inherited $50,000 or more suddenly that they never would have in a normal year. What did they do with that money? Down payment. By the way, a little bit of that is still going on because it takes a while for some of the estates to settle. But by and large, that part is over. And by and large, people are going back to where we started. People are back to spending and trying to travel normal. So, the savings rate has come down. So, this abnormal spurt of down payment is kind of over, and we’ll go back to something much more normal going forward with down payment capacity on the single-family side. Doesn’t mean single-family collapses. The best thing single-family has going for it is that under production we talked about. So, I think single- family does well, but it’s this glory moment of the flood of down payment capacity is pretty much over, not completely, but you get the point.
Montesi: Yeah, do you think there’ll be some downward pressure or substantial slowing in lifestyle market, the Santa Fes, towns in Colorado, etc.?
Linneman: Boise, etc., yeah, of course.
Montesi: Where people moved because they could work remote and they could have a more interesting, fun, outdoorsy lifestyle, do you think some of that will revert back and people will move back to the city and sell those houses?
Linneman: Whether they sell them or keep them as a second home or try to rent them out, I’m not sure. That part’s a little more difficult for me to figure out. I do know that all of California isn’t going to move to Boise or Santa Fe. I feel a hundred percent comfortable to say all of San Francisco is not going to move to Boise or these boutique markets, and all of New York isn’t going to move to Long Island for the rest of history. Now I do think, for example, Miami, South Florida has gotten a fundamental push in that the dissatisfaction with taxation and the local government’s response to some things broke inertia. Come on, you and I knew a lot of people in New York who were saying it just, this is crazy, and it kind of broke some inertia. But the thing I say about cities, and I’m a big believer in cities, cities are economically productive, they’re socially productive. And when you shut them down, they were neither economically productive nor socially productive. Once you let them open up and once you let them get back to equilibrium, which will not happen overnight, they’re going to be the engines of social and economic progress. And I include not just New York and Chicago. I include Denver and Houston and all kinds of real cities in that regard. So, people are going to come back. And the comment I make is, after World War II, Berlin was completely destroyed, split, etc., and yet, as soon as possible, literally as soon as possible, we then embarked on a process of rebuilding Berlin. And you can go through cities – Tokyo, completely destroyed during World War II, but it was such an engine of economic and cultural and social growth, they rebuilt it. London, same way. You can go to city after city, and that’s because they are powerful economic, social, and cultural engines.
Montesi: Thanks, Peter. We’ve just endured a one in a hundred-year sort of unique event. And this is after a multi-year strong economic recovery or moderate and then strong economic recovery. Typically, we would have thought we were getting near the end of a cycle. So, when you have this event and we go down deeply, the economy shut down and now we’re just starting to rage back, what is your view on where we might be in the cycle or whether this is a reset to the start of a new cycle and what can we learn? What can we be watching for?
Linneman: So, I think two things. It definitely was a reset. The economy did not have wild excesses in 2019, or January, February of 2020, but there were some excesses. There were some, typical late cycle excesses. I don’t think it was tragic, but we had some. That got reset almost across the board.
Montesi: Well, I noticed your canaries in the coal mine were almost universally reset.
Linneman: Almost reset. It was a huge, huge shutdown and reset essentially all the calendars. So, I do think it was an absolute reset and may have been one of the greatest resets we’ve ever had. And the fact that we borrowed from our future, that we borrowed both particularly at the federal government level, we borrowed from our future capacity, maybe, I don’t know, half a percent of our future wealth and transferred it to today, that puts a lot of engine in the machine, the economic machine. So, I think that’s critical. And we’ve not only reset by wiping out whatever excesses were there, but we’ve turbocharged it by we saved, we forced ourselves to save, and we collectively borrowed from our future. And we now got resources leftover to move into the future with. The second thing is, I’ll tell you what I’ve thought a lot about – again, I had my 70th birthday in March.
Montesi: Well, happy COVID birthday.
Linneman: Yeah, wonderful. I’ll tell you what I got thinking about. There was this event and then there was this event, and like the Berlin wall went up when I’m a kid or Kennedy’s assassinated, and you can go right through history, the financial crisis, 9/11, and so forth, this, and what I was struck by is about once every eight years, a once in a lifetime event occurs. It’s not the same once in a lifetime event, but kind of for real, not joking, about every eight years or so, a once in a lifetime major resetting event, whether it’s resetting us as individuals or business or government, occurs, and you could do that pretty easily on and on, some of them good once in a lifetime, some of them bad.
Montesi: Yeah, sounds a little like who they named the George Washington bridge after. It’s like, how many once in a lifetime events happen in your lifetime? Well, every eight years, and if you live to 80, ten.
Linneman: Ten. The reason I say that is, as we think about this reset, I think it’s within eight years is going to be another once-in-a-lifetime event. I don’t know what it will be. It could be a wonderfully good once in a lifetime event, like the fall of the Soviet Union was. It could be a terrible once in a lifetime, like the one we just lived through was, but I do think that if I were to tell your listeners something, it is be prepared for once in a lifetime events to shake up your perception of life in the world like once every eight years.
Montesi: Interesting. From your perspective, as you look forward and think about the future of outdoor retail, malls, mixed-use, and developments, what are some of the things that occur to you and has the pandemic and e-commerce changed or impacted your view?
Linneman: To a first degree, it has not changed my views. To a second degree, yeah, around the margins. I’m just going to take dining as an example. In most places around the country, weather permitting, dining outdoors was slowly growing pre-COVID. You’d kind of agree that more and more, there was an outdoor dining component.
Montesi: Yeah. That was now it’s been supercharged or accelerated.
Linneman: Yeah, that’s been supercharged. It will probably withdraw slightly, but people enjoyed that. That’s why they do it, one of the things you like about going to Brussels or Venice or Paris or whatever is, and we didn’t do it as much for whatever reason. We didn’t do it in our shopping centers. We didn’t do it in our cities nearly as much. I think something like that as an example is more permanent. Let’s just put it that way. And we’ve even figured out how to do it if the weather’s not great, can’t be awful, but we’ve figured out how to do it if it’s not great. So, God bless ingenuity. There are other things of that nature, but that’s why I say that’s a second order. That’s an execution matter, not an existence matter if you will. So, that’s what I mean by the first order, I don’t think existence has changed a lot. However, you’re going to have to tweak your centers, but you always have tweaked your centers. That’s not new. And you’re going to have to tweak them, like I can imagine a lot of supermarkets wished that they had an outdoor dining capacity, indoor and outdoor dining capacity. Okay so, you’re going to tweak your product.
Montesi: Or better delivery infrastructure.
Linneman: Exactly. So, first order, no big change, but remember, what keeps you and your team busy is usually not the existence question, it’s the execution at the margin. It’s all those tweaks. So, you’re going to be busy, but you were always busy doing it. And some of them have been shown up or some light been shed on the direction a bit more clearly than was there. But I think of the outdoor dining, there was always the person saying I want more outdoor dining space at my restaurant. Now, you have a lot more saying that.
Montesi: Any commentary on malls and the future of malls, department stores, etc.?
Linneman: Bad malls are bad malls. Good malls control a location that is very hard to recreate and become a hub and a center of activity. And what takes place in those has changed constantly over the history of malls. But if it’s a great mall – what’s a great mall? I don’t know. Short Hills Mall or Schaumburg – Woodfield Mall.
Montesi: North Park in Dallas.
Linneman: North Park, right. They’ve done nothing but evolve over time. If you went back and looked at the original layout and the original tenancy of those centers, you’d be shocked at how much they changed between then and 2019, even though the change happened organically. And so, you didn’t appreciate how much. It’s like do you ever go back and look at your pictures? You don’t think you’ve aged much. And then you look at your picture when you were 30. My wife and I just had our 48th wedding anniversary and we looked at our wedding photos, and we go who the hell are those people? Even though to us, we look the same. That’s what’s happened to those great malls. They’re still great. They’re changing what’s great, they’re constantly having to work, but they are locations that are centers of economic activity. They’ll constantly change. When I’m a hundred, I hope we’re doing another one of these, Terry, and I hope shopping centers are still being challenged to change yet again, yet again, yet again.
Montesi: Yeah, they will. Well, my last question for you is trends and external factors to be on the lookout that you believe are going to drive and impact real estate in our economy, say over the next five years?
Linneman: The biggest one – I’m kind of a voice in the dark. I have a book that comes out – National Geographic is publishing it with Mike Roizen and Al Ratner. Mike Roizen is the Head of Wellness at Cleveland Clinic. And it’s about people living longer and healthier, unless you’re a drug person, which has clearly dragged us down in terms of life expectancy. But those of us that are not that are seeing our lives go longer and longer. And medical breakthroughs are going to be more and more dramatic, genetic and otherwise. And just thinking of what we just lived through with COVID vaccines, how quick and dramatic that was. Imagine that with arthritis, imagine that with cancer, imagine that etc. Now, I don’t know if that happens in five years or ten. So, I do think the next five years, ten years are going to be dramatically affected by massive medical breakthroughs that will begin to be adopted. And what has already happened is, and it’s not because I’m a Boomer I’m saying this, is that the Boom is the wealthiest, healthiest, highest income group in the history of mankind. And they’re going to live a good long while, and they’re going to live pretty healthy, and they got a lot of money, unlike anything we’ve ever seen before in history. And they could get medical breakthroughs that actually could reverse a lot of the deterioration over the next five to ten years. I encourage people when the book comes out to get some of the science of that. And we can certainly afford for them to live. In fact, we can’t afford them not to live in a funny way. And that’s what I see as the biggest change over five to ten years.
Montesi: What would the next biggest trend on your mind be?
Linneman: We appear to be on the pendulum of growth versus redistribution that has swung all my life, the national level. There’s a bit of a pendulum between favoring redistribution a bit at the margin over growth at the margin. We appear to be in the last year or so in a phase of the pendulum swinging to we’ll sacrifice growth for redistribution. So, I think in the near term, let’s say two to five years, that is a notable trend. Now, by the way, remember when the pendulum swings, it doesn’t swing to expropriation, or at least hasn’t historically, any more than when it swings in the direction of growth. It’s like a bare-knuckle boxing, laissez-faire. It’s all these little swings, but I do think we’re in a period – good or bad, that depends on your own view of the world – but I do think we are in the next five years, probably pendulum swinging-
Montesi: Towards redistribution. Yeah. So, the last thing I’ll ask, what sectors in real estate do you invest in the next five years?
Linneman: On capitol market depth and pretty good fundamentals, multifamily for long hold. For underlying supply-demand, imbalance fundamentals, industrial warehouse space. And that’s because the simple math is everything sold through an online takes about three times the warehouse space as if it were sold in a store. And that creates- It is very hard to overbuild given that mathematics. So, I’d say those two.
Montesi: Those two. Well, thank you. It’s always good to hear your voice. And blessings to you and hope that I’m talking to you 20, 30 years from now, Peter.
Linneman: There we go. Thanks a lot, Terry, have a great day.
Montesi: Thanks, you too. Bye-bye.