2022 State of The Industry with Dr. Peter Linneman (Part 2)

Dr. Peter Linneman and Terry Montesi finish the second half of their discussion on COVID’s lingering impact on each real estate sector, and specifically the evolving single and multifamily housing markets. Peter explains how office and lifestyle trends after the pandemic have impacted urban and suburban trade areas. The pair also evaluate Peter’s perspective on inflation, and if having real estate is a good hedge.

Leaning In is published every second and fourth Wednesday of the month. You can find the first half of Terry and Peter’s discussion on your preferred podcast app. Tune in for our next episode with Josh Grillo, Co-Founder and President of Resident360.



Terry Montesi: On today’s episode, I’m back with Dr. Peter Linneman, Principal of Linneman Associates, to finish our conversation on real estate trends and predictions for the new year. We pick up from last time when Peter joined us in 2021 to discuss how the single and multifamily housing market have evolved and how COVID has impacted all types of real estate.

So, Peter, when I’ve asked you the past 5, 6, 7 years about where we are in the cycle, you would always say it’s already gone on a long time and who the heck really knows, but I’ll answer it anyway. So, your confidence level wasn’t crazy high. Is your confidence level that we got a new clock and this is early in the cycle, is it higher than-?

Peter Linneman: Really high, really high.

Montesi: Higher than it was when you answered that question three or four years ago?

Linneman: Yeah. Higher than the last four years. It’s kind of where I would have been in late 2009, 2010. And by the way, in 2010, did I think things would run to 2020? No, but I surely would have thought they’d run to 2017, 2018. 

Montesi: Yeah, back in ’09, ’10, you were confident we were early in a new cycle, and you are that confident today?

Linneman: Yeah, absolutely.

Montesi: Well,  I’m glad I asked that question. That might have been the biggest value add that having me on today brought to the table. The urban suburban trade areas, secondary markets versus large markets, those are some things that a lot of people spend a lot of time thinking about, this sort of office trends, lifestyle trends post COVID, it’s impact on trade areas, urban, suburban, and secondary markets versus large markets. What are your thoughts on those?

Linneman: On retail? You are talking more retail?

Montesi: No, not so much. I mean, that’s really lifestyle, office, could be retail, where do people want to invest and live, secondary, largest. It’s not just retail.

Linneman: Okay, so suburban- I’ve been in this rare voice, I’m not the only one, like Joel Kotkin and several others for the last 10, 15 years have always said don’t confuse the fact that the urban cores are doing much stronger in absorption in apartments, which they have been, there’s no doubt for 10, 12 years, don’t confuse that with there’s more young people who want to live in the city than in the suburbs. The suburbs have always attracted more than the city, just not as many more. And so that was a big adjustment. I think that kind of continues. The suburbs will still be the dominant location, including for young renters. Not just for every cool young renter you see in the city, there’s like two of them out in the suburbs. They’re just scattered, so it’s harder to find them. But if you go to the Easton Town Center, you go to any of those places, they’re there, they live out there. So, I think the suburbs still do quite well. The strong suburbs do better. The strong suburbs are largely defined around, anymore, around an active job node, an active office job node and an active retail node. And they feed off of one another. They don’t have to be walkable. I mean, walkability is nice, but let’s face it, the reason people live in the suburbs isn’t because they want to walk. I think that’s a misnomer. When you go- imagine I went to Montana. Well, Montana is a bad example; they want to walk, but in a different way – they want to hike, not walk. But the reason I moved to Montana was not so I could walk to work. I know I need a car. I’m there for other reasons. The reason people move to the suburbs is not generally walkability. That doesn’t mean they don’t like some walkability, but it’s not why they’re there. The reason I live in the city and I’ve lived in the city my whole life is I don’t like to drive. I really don’t like to drive. I haven’t owned a car for, I don’t know, 25 years. And for the 20 years before that, I was driving, like grudgingly driving, 1500 miles a year. Now, I am extreme. I want walkability. And by the way, more people like drivability than walkability, it is true. And the older we get, the less attractive walkable becomes, especially if it’s walk ups and so forth. So, I don’t think that’s changed. I think the urbans do fine. The urbans have a big problem of perceived and actual safety, and in many of the urban areas, Philadelphia included, unfortunately, near or record homicides are being set, crime has shot up. It’s particularly in some neighborhoods tragic. Those are livability issues that – New York being a poster child, San Francisco being a poster child, Philadelphia being a bit of a poster child, Chicago being a poster child – why would I want to live down there if there’s no livability? And so that’s a challenge. I think that governments in spite of themselves will rise to the task, not immediately, but will rise to the task. It may take some time. But I never was anti suburban. I always have lived in the city, so I always saw the advantages of the city. They’ll both continue. They’ll both continue with some strength.

Montesi: Any comment on is there going to be any change, and this is thinking about investing and population migration, to secondary markets, smaller markets versus large metros?

Linneman: You heard it here first. Bozeman, Montana, is not going to become New York City in the next 20 years.

Montesi: Dang. I was thinking the opposite.

Linneman: It’s not like everybody is going to say, I’m going to now go to Bozeman. Now that I don’t have to, I’m going to go to Bozeman or name all the others. I’m not picking on Bozeman, just all the remotes. They are not going to become to New York City in 20 years. They’re not going to become Chicago in 10 years. They’re not going to become Philadelphia or Boston. By the way, will they have growth? Yes. Might this enhance their growth a bit? Yeah. But I just don’t- Think of Denver. Denver has been a wonderful place as a niche place for a long time, Raleigh been a wonderful niche place for a long time, and yet, 20, 30 years later, they’re bigger than they used to be, they grew faster than the old style. But come on. There’s still a lot of people in Los Angeles. There’s still a lot of people in New York, still a lot of people in Philadelphia. When I say that, I don’t mean the city of, I mean the area.

Montesi: The Metro area, got it. So, one thing we didn’t talk about regarding inflation, just a quick question, what is your perspective about the sort of age-old observation that real estate hard asset is a really good inflation hedge? Do you believe that?

Linneman: I do believe it with one kind of qualifier. So, I did research on my own and then also with my colleague, Joe Jercho at Wharton, I think our research was done in the eighties of the seventies in the United States where we had high inflation, on a sustained basis, we had high inflation. And what we found, and I think others who subsequently looked at it found, was by large, it’s a quite good hedge against inflation. And on top of that- let me explain what I mean by hedge against inflation. It was a good hedge against inflation in the sense that rents sort of tracked. Yes, so did your operating costs, but your NOI therefore kind of tracked inflation. And on top of that, construction costs, replacement costs actually not only tracked inflation, went up a little faster than inflation, so you got that as your floor rising. So, it was a good hedge against inflation in that sense. Was it a perfect hedge? No. Think of an office building with a 10-year lease, flat 10-year lease. Over a 20-year period, that’s probably a good hedge against inflation, but in the first 10 years, that’s not a good hedge against inflation because your rent, in the example I’m giving, the rent’s fixed and your operating costs are going up. But what happens when the lease expires? Everything adjusts up and you catch up. So, it’s not perfect. Multifamily works best that way, hotels work best that way, because they’re marking just more often. So, the longer the lease, they were good hedges against inflation, but it was a lumpier hedge. To put it this way, you can go broke on the operating costs going up while your lease keeps the rent flat before it becomes the inflation hedge.

Montesi: Unless you’re in the multifamily or hospitality business.

Linneman: And that was the beauty of multifamily and hotels. So, we found it was a quite good hedge against inflation in that sense. And then on top of that, the fact that largely back then people had fixed rate loans, as inflation occurred, you were paying back with funny money. Your debt was depreciating by inflation. So, for big inflation with fixed rate debt, you want to be a borrower. On a fixed rate, you want to do that. Now, here’s the- so I think that will be true again if we get large inflation sustained. What if we have 6% inflation for six months? I don’t think so. I mean, yes, but not necessarily so much. It’s just not that perfect. So, if you then look at the research on inflation hedging in the United States, since about 1984, the data is since 1984, you don’t find real estate as an inflation hedge. Why? Because what you’re looking for is the correlation between NOI and inflation. Now think of the data you’re looking at. Inflation went from 1.6% to 1.7%. Do you really think your NOI went up by 10 basis points at the same time? No, there’s so many other factors impacting NOI. Then inflation went from 1.7 to 1.55. Well, there’s so many other factors happening in your NOI, so then if you just think of it as a statistical phenomenon, inflation wasn’t high enough for its variability to show. Interestingly, what you do find over a big picture is it more than outstripped inflation, and that’s the construction costs, that’s the replacement costs phenomena. And the reason replacement cost goes up faster than general inflation is the labor component because labor is getting real productivity, and that’s pushing it up faster than commodity, if you will. Commodity kind of goes up and inflation, but commodity plus productivity goes up faster than inflation and that pushes it up. So, in a big picture, even with small inflation, like a decade. So, if I look decade and come back a decade later, yeah, it’s a good hedge against inflation, but not in the month to month, quarter to quarter when it’s bouncing around from 2.1 to 1.9. And by the way, that’s not what you were thinking when you asked the question, but that is- somebody in the Wall Street Journal or somebody like that is going to publish that in the last 25 years or 30 years, commercial real estate has not been a good hedge on inflation based on somebody’s research, but it’s based on the research in the way I just described it. And you go, well, of course not. But if you look at it as the last 20 years, the last 10 years, last 30, it is, but not in the data observational sense. So, your readers are forewarned about that article coming up. But yeah, it has to be a good hedge against inflation. And shorter leases hedge it better. Particularly in high inflation, shorter leases hedge it better.

Montesi: Yeah. So, in an increasing inflation market, it makes multifamily and hotel ownership, it props them up a little relative to the other sectors.

Linneman: Props them up a bit.

Montesi: What about the quest for yield for institutional investors and how does that affect the appetite for real estate and their long-term rotation out of financial instruments, which have been yielding such a low yield for so long? Put your thoughts on that and where you see that going in the future.

Linneman: I think it’s a combination of inflation will drive- the fear of inflation, whether it turns out or not, the fear of inflation is going to push more money into real assets, like real estate but not just, the stock market and others. And super low interest rates already pushed a lot of people into real assets, I have a chance assets, go back to what we were talking about, fighting chance. It’s one thing if you say inflation is 2%, the bond yield is 3.5%, could do a bit worse, could do better, but I’m going to make money. I have a fighting chance to make money. When bond yields got down below inflation, and in many cases around the world, truly negative, I don’t have a fighting chance. From the minute I invest, I know I’m going to lose. I know I’m going to lose. That made assets that gave me a fighting chance more attractive than they were before real rates became negative and nominal rates became negative. And I think we’re in for- I think go back to what I said, I think maybe the ten-year treasury might get to, I don’t know, 2.5 this year more or less, and inflation could be easily 4-4.5%. So, there’s a negative. So, you still don’t have much of a fighting chance. If that’s the case, I still like real estate. I still like the stock market. At least I have a fighting chance. By the way, I may not win that fight. I may turnout saying I didn’t win the fight, but at least I had a chance to win. I don’t have a chance to win in certain assets.

Montesi: Got it. Well, I’m done.

Linneman: Happy New Year and stay healthy.

Montesi: Wish you a great 2022. Cheers.

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