Thought Leadership Interview with Peter Linneman
An in-depth series of discussions with industry leaders led by Trademark Property Co. Chairman & CEO, Terry Montesi and President, Tommy Miller
MONTESI: Let’s start with what is going on with retail sales?
LINNEMAN: You take retail sales and you back out auto and you back out gasoline. You do the same thing, right? And in real terms, it’s at a new all-time high slightly. Just barely at an all-time high. It’s higher than 2008 but only by a percent or so, net of CPI.
MILLER: That’s real, not nominal?
LINNEMAN: Yes. Nominal would be 9% above, something like that. But most of it is just inflation that occurred. When I say inflation, I’m just meaning CPI. I’m not doing anything cute. And again, it says that we’re down. We’re roughly 1.5% higher than the previous peak. But we’re 4.5-5 years later, almost 5 years later, and we’ve had about 4% population growth. Remember, I told you GDP is back to essentially the same on a per capita basis? “Store sales” are not back on a per capita basis. They’re up 1.5%, and you’ve had the population grow about 4.25%. So you’re down about 3%, and you say well how did that happen? And how that happened in particular is gasoline and fuel products. They rose faster than inflation, and that’s kind of the gap, as it were. But it’s not horrible, it’s not great. The thing for your business is, the reason I corrected and said they’re not literally sales through stores, is if you back out the way you do, the internet driven sales, although it’s only a small part of the whole – if I’ve told you that we’re basically 1% ahead, or 1.5% ahead on everything that’s not gasoline and autos, you know that internet has basically accounted for all of that growth. And in fact, if you do a little manipulation of what internet sales are, it means sales probably through stores. In other words, it may have been sold by a traditional retailer, but not necessarily through their store. We’re not just talking about Amazon. The data in stores is down in real terms. The best I can come up with, is that it’s down by about 2-3% from its previous peak. Up from the bottom, but down from its peak. Well, nobody has a perfect number for on-line sales – I’ll tell you what I’m doing, I’m taking the number we just backed, and then you get these numbers that float around from ICSC and others of internet sales, and you kind of back it off. And you say what they believe internet sales were five years ago, and back it out. But remember, companies don’t report internet sales. So you don’t have pure data. They’re probably not crazy off, but they‘re not pure data.
MILLER: Peter, is that a negative for the bricks and mortar when you look at that on-line sales number?
LINNEMAN: The real data from bricks and mortars is probably down 2% from its peak in ’08. But it is well up from its bottom in the end of ’09.
MILLER: Got it. So maybe there’s upside if there’s GDP and job growth after the peak.
LINNEMAN: I see upside. So it’s improving, but not as fast as on-line retail sales. Because you can imagine bricks and mortar vs non-bricks and mortar, and you know the non-bricks and mortar is growing faster than the bricks and mortar. So if I tell you that sales overall are growing in real terms at 2.5%, which is about right, then you know the bricks and mortars is growing slower than 2.5% just because it’s the weighted average. But the real problem is there’s not good data on the split between bricks and mortar and internet.
MILLER: Is part of the reason sales aren’t tracking with GDP and job growth due to the types of jobs being created?
LINNEMAN: The big limitation is that the middle and lower-middle jobs are heavily skewed to things like housing production, and all the ancillary services that are provided for housing. And auto sales are just back to almost a historical norm. Almost. They’re off by about 7% from the long term norm. But let’s even call that norm. But for the entire period of recovery, auto sales have been way below norm.
And then you come to single family housing. In a normal decade, and I’m rounding, you’d produce about 1.2 million homes a year, some years more, some years less. And if you look back on a normal decade, it’d also be about 12 million homes in ten years. Some big homes, some small homes, some different locations, different sizes, different price points. You just need it to offset floods and fires and hurricanes, and to deal with population growth. Well, we had the floods and fires and hurricanes and population growth, but we only built 10,600,000 homes, roughly, so we’re about 1.4 million short over the last decade. All of which was in the last five years. So we’ve got a fundamental period of under production of housing. And if you do the math and you say, okay, a million and a quarter homes that would normally cost about $200,000 each, and then you put a multiplier on all the spillover jobs, like moving vans, and mortgage servicers, and title search, etc., you’re talking like $800 billion additional on a $15 trillion economy. So, we’ve deferred the production of single family housing, to a tune of almost $800 billion dollars including spillover effects. On the multi-family side, we’ve deferred the production over the last decade of a million multi-family units. We had the floods and fires and hurricanes and population growth, but we didn’t build homes. And that adds about another 250,000 if you go through the same kind of math. So between the two, you’re at about a trillion-one that’s just pent-up, and has to be factored in sooner or later. It’s deferred construction, if you will. And by the way, you can defer it for a good while, it’s not so hard. Kids live at home, etc. But at some point, you’ve got to deal with it. So we have about a $1.1 in economic impact including spillover effects of deferred production of housing. Those jobs are heavily middle class oriented. Brick layers, truck drivers, real title search, etc. By the way, you can do the same economics on auto. Auto’s about another $300-$350 billion, deferred in the same way, if you do the same math. And again, those are statistically normal jobs. And where the economy has been weak is on the lower half of the income distribution. And if you look at this, you’d say well, one of the reasons why is you’ve got a $15 trillion annual economy, you’ve got this huge deferral that’s directed at the normal and below normal economic strata. So I think that deferred building gets done. I don’t know if it gets done in six weeks, the next six months, but it gets done in the next six years, and that’s good. That’s a tail wind that people have not factored into their numbers.
MILLER: That would be just classic pent-up demand.
LINNEMAN: Pure pent-up demand.
MILLER: Peter, population growth historically averages 1 to 1.1% a year, but recently it’s been more like 0.8. Is this caused by a sluggish economy?
LINNEMAN: Yeah, it’s more like about 0.9 to a little below 1. But you’re not so wrong by calling it 1. And it’s running about 70 basis points now. It’s off about 25 basis points, which is nothing in a year, its rounding error. On the other hand, if that’s a permanent change and continues for two decades, that’s significant. And we don’t know the answer. We are 4-5 years into this downturn and there is no census year to benchmark against, so the precision is pretty low. The drop is within statistical standards, but, it gets your attention. Not the first year it occurs, but the second, third, and fourth, you do start noticing the decline. The question is, how much of that population decline is related to immigrants, which – think about the jobs we just described, right? I mean, the comment I made the other day when somebody asked what I thought about the immigration and the building of the wall down on the Mexican border, and I said, “Well, I just hope we build the wall from the Mexican side rather than the U.S. side,” and somebody said, “Why?” And I said, “We don’t have anybody in the U.S. that knows how to build a wall!” If you think about that immigrant phenomenon, it is economically sensitive.
The birth rate part of the equation does not seem down as much. The birth rate part is not down as much as the immigrant part of the decline in growth. So you can imagine that reversing on us, particularly for lower and middle-quality job economic strength.
MILLER: Yeah, I was wondering if it had something to do with household formation patterns, you know, the traditional family becoming less and less normal, and alternative families becoming more normal?
LINNEMAN: Too soon to say. My gut is no, but I don’t have a crystal ball. And if you say, ok I’m going to hold a gun to your head, and I’m going to hold you accountable in five years, I would say if we get that pent-up construction occurring, we will look back at this as a blip. Because you’ll get the immigration more than offsetting anything else. I don’t know if I’m right, but that’s what I’d say.
MILLER: You think about all the kids living at home in their 20’s, you know. They’re deferring getting married, right?
LINNEMAN: That number’s down to about 700,000 at this point from a peak of 2.2 million. It’s come well down, and it’s come down as job growth occurred. It’s actually about 650,000 above normal, doing that. Off from a peak of about 2.2 million at the start of 2010. I mean, it skyrocketed in ’08, ’09, and early ’10, but then it’s come way down. So that’s worked off a fair amount, that’s why the multi-family market’s gotten so healthy.
MILLER: Anything to talk about in terms of the impact of Obamacare, taxes, etc.?
LINNEMAN: Look, it’s all bad.
MILLER: Consumer confidence?
LINNEMAN: The uncertainty is the problem. Bad laws are nothing new, we’ve had them forever and we learn how to deal with them. It’s not like the old health care was a good program, right? The problem is not that the old system was good, it was a bad system we knew. Yes, Obamacare will cost more, etc. To me, that’s less a problem than, do you know what it will really mean, have you guys really figured out what you’re going to do? Do we know how much more expensive it’s going to be for the country? And the answer is, we don’t know any of those. So the uncertainty is the challenge. And the regulatory environment and the Fed have created uncertainty. We’ve never seen a Federal Reserve System put three trillion dollars into the monetary system. We’ve never seen a situation where they put so much money in but it basically hasn’t come out. So everybody is asking—this is the tapering question, when will they stop? And does it matter if they stop?
MILLER: We are in unchartered territory and no one really has the answer?
LINNEMAN: No one knows. In other words, you guys have been in business a long time, you’ve never seen interest rates as low as they’ve been. So if I say to you honestly, in a quiet room, just us… do you really know how to invest in this interest rate environment? Your honest answer would be no, because we’re never seen it before and none of my mentors ever saw it before. And if I said to you, do you know what happens when a Fed that’s buying 85 billion a month stops buying? You certainly don’t know what will happen when they stop because you’ve never seen it, but I’ve got to do something. It’s not like we aren’t making best efforts, but everybody is in an environment with no historical analogies.
The federal deficit is another big issue – we’ve never seen a period of large and growing federal deficits in peace time. I understand young men and women were being killed in Afghanistan and Iraq and I’m not trying to minimize it. But you know what I mean by basic peace time. We’ve never run five years of deficits like we ran, except in the Civil War, World War I and World War II. We just never did. So if you say to me, what really happens when you run those kinds of deficits for five years running during peace time? I don’t know, because I’ve never seen it before. That’s why I think it’s the uncertainty. Why do I want the Fed to start tapering now? Because I don’t know what happens when they buy, and I don’t know what happens when they sell, but we’ll find out, and that will reduce uncertainty. And I think reducing the uncertainty in and of itself will be a plus.
Why do I want Obamacare to kick in without the, whatever they call it, the starvation effort? Not because I think it’s a great law, but it would be clear that that is the law. Why would I actually like to see them pass a real tax bill, which we haven’t had for five years? So that you and I would at least know what our taxes are going to be three years from now. On and on, right? Why do I want them to raise the interest rates? Because I don’t think low interest rates are helping. It’s hurting as many people as it’s helping. So all the low interest rate thing is doing, is benefiting those who are borrowers, and it’s killing those who are lenders.
MILLER: Peter, can you give us your best forecast for interest rates, the stock market and the housing market, which I know you follow so closely?
LINNEMAN: First, interest rates have to go up. I’ve said it for three years.
MONTESI: You’ll be right sooner or later?
LINNEMAN: It’s like, we’re all going to die. You know, maybe we’ll be the first generation that doesn’t, but I doubt it. And in the same way, interest rates are going to rise. They’re not going to rise on something fundamental, they’re going to rise on something non-fundamental. And if you think about, the 140 basis point increase in interest rates when Bernanke said something that now he swears he didn’t say, but everybody else believes he said. He swears, and I think he believes, that he said nothing. Rates are going to rise, both on the short end and the long end, and when they do, you’re going to look back and say, well of course I saw that coming. Interest rates are going to rise, and the problem is, you can’t fight a determined sovereign. What you’ve got is a determined government, and the government is big and strong and well-capitalized. And determined sovereigns can’t do crazy things forever, but they can do them for a long time. That’s what’s going on. They believe they’re smarter than the market. And so you have the classic problem of nine smart people believing they’re smarter than 310 million not-so-smart people. The question isn’t, are they smarter than the other 310 million? I think the Fed is hurting the economy. When they raise rates it will actually help the economy enormously by eliminating uncertainty. It will help the people that have been hurt and hurt the people that have been helped, but, net, it will eliminate uncertainty and let the market allocate capital instead of the Fed. I think all those are good things. My guess is that Yellen will not want to raise rates in her first six months because it’ll make it look like Bernanke was wrong, and she won’t want to do that. So I think the short rate stays down well into next year no matter what, on this kind of, “I don’t want to make my predecessor partner look bad.” She’ll make a statement that she’ll swear she didn’t make, and rates will move another 140 on the long end. You could easily be looking at 4, 4.25% within six months on the ten year.
On real estate pricing, it says lock long term debt down while you still can. What I think happens is, when rates rise on the long end, buyers will temporarily disappear. Sellers will still be in the market. Cap rates will therefore move up. Remember, buyers generally don’t have to buy as much as sellers tend to have to sell. That’s why, net, I think the cap rates will rise as the interest rate moves. That’s what you saw happen when Bernanke said what he didn’t say. And there are more buyers who have discretion than there are sellers who have discretion. And that’ll cause cap rates to go up. As the landscape becomes clearer, the cap rate will come back down. Cap rates have the ability to come down about 100 basis points, even if rates rise. If interest rates went up, cap rates have a cushion in them because the spread is still wider than normal.
Let’s say the cap rate for your asset rate is 5, okay? If you believe it’s a 5 now, when Yellen says something she believes she doesn’t say, and the ten year goes up 100 basis points, 120, your cap rate if you have to sell will go from 5 to 6.5, which is to say, do you really need to sell in that window while people sort it out? So 100 basis points caused 150 basis point movement upward. And then as people realize over the next month or two after that the world isn’t coming to an end, you’ll see it drift back down towards 5. If rates rise more than about 100 to 150 basis points, you’ll see cap rates stay up. That is to say, because, that’s about how much cushion you’ve got in spreads vs normal spreads. So there’ll be a panic effect in the uncertainty. And some of the sellers disappear but not all of them will reappear, and you’ll get some reduction again in cap rates. As you push beyond an interest rate rise on the long end of more than 100 basis points, it’ll come – let’s say it was a 200 basis point rise in ten years, from a 5% you’d see the cap rate go to 7.5 temporarily, and then it would come back down to some number like 6. And that is to say, it would go to its normal spread, but the interest rate movement was wider than the different normal spread. So you’ve got some cushion, but you don’t want to be in the market at the wrong moment. You don’t want to be borrowing at the wrong moment; you don’t want to be selling at the wrong moment, because strange things could happen.
A real recovery, I agree. We have only gotten back to where we were pre-crash. The real recovery has not remotely begun. You can put different faces on it, whether it’s GDP or other measures. Is the unemployment rate a perfect number? No. But it’s a number. And the unemployment rate is still 7.3%. If I would have told you, and almost any time in your business career, 7.3% unemployment rate, is that a strong economy, a weak economy, or a mediocre? You’d say it’s a weak economy. So, even though it’s been a recovery, it’s only been a good recovery to a weak economy. Remember about two years ago my catchphrase was “a strong recovery to mediocrity. We’re not even at mediocrity yet. I don’t even think mediocre starts until around 6.5 to 7% unemployment rate. We’re not back to the same number of jobs we had at the peak. So, true economic growth has not set in yet in most markets. Now, in Houston there’s some economic growth, in Dallas there’s some real growth. But in Los Angeles, none. So as a general matter, it’s been the bounce from the bottom back to around where we were, as opposed to growth from where we were. Unless you think it’s the end of history, and we never advance from where we were. It’s unlikely. In my lifetime – and I’m 62 – I would always bet against it being the end of history.
Now, I do think that it has some implications. I gave a talk the other day for investors. And I said, the funny way I view the economy and the opportunities ahead for real estate is, imagine the settlers walking across America, heading to California in the old days, and they went across Illinois and Missouri and Nebraska, and it was pretty flat. And yeah, it was hard going, but it was pretty flat. And then they got to Colorado. Well, Colorado is flat, but it’s slowly upwards sloping until you hit the mountains. There’s an increase. Denver, after all, is a mile high, and the Mississippi is essentially sea level, if you think about it that way. So it was easy going in the sense that it was pretty flat, but it wasn’t as good as back there in Nebraska, because we are climbing a slight slope. And then you looked up and you saw those mountains, and you said, “Oh my God, that’s terrifying! How am I going to get on the other side?” So you took extra provisions, you waited until the right time. So you time yourself, you discipline yourself, you don’t take as much debt. On the other hand, as you work your way through those mountains, you’re going to find amazing valleys, amazing livestock, you’re going to find minerals, you’re going to find water, you just don’t know where. And, by the way, on the other side is the Pacific Ocean if you ever get over it all. So there’s great stuff, but it could be bumpy.
So you could buy a center – just be prepared that it may not be the right time to buy. You could be wrong by a year, and things get worse instead of better. You want enough maneuverability, operationally, capital, etc. Because I think what you’re saying is right. The true economic growth, I mean growth, not just get back to where we were – is going to happen. Just go back to what I was talking about – just housing alone can stimulate. But it could be an unpleasant road, and you may encounter some cold rivers, and you may have to backtrack, because what you thought was a pass is a dead end, and you may have to traverse, but it’s going to be worth it. So you want to dress yourself up, and provision yourself for a tougher journey than your life history has prepared you for. Because I don’t know what happens when it tapers, and I don’t know what happens when interest rates rise, and I don’t know how Congress is going to eventually close the deficit, and I don’t know how Obamacare is going to work out, but you know what? I do know it’s going to work out somehow, I do know they’re going to deal with the deficit somehow.
MONTESI: The best prescription for that is lower leverage. Is that right?
LINNEMAN: Lower leverage and longer leverage. That’s the simplest. Let’s say you’re normally a five-year holder, then go into it as an eight-year holder. If you’re normally an eight-year holder, go thinking you’re a ten-year holder. By the way, you might cash out in two years, that’s different. Everything went great. But I would go in with a mindset that my hold periods are longer. I’d go in with the mindset of, make sure I’m around when the good times occur.
MONTESI: I feel like that story has just played out for us, because were busy in ’05, ’06, ’07, ‘08’, we hunkered down like crazy in ’09 to try to survive. And we have been reasonably able to recover and harvest.
LINNEMAN: Think about it, you’ve got your cash flows – I would bet you’ve got your cash flows back to the same in real terms, which meant in nominal terms, they were 6% higher, 8% higher, nominally, some number like that.
MONTESI: Oh, absolutely.
LINNEMAN: But there was a lot of brain damage, and you may have had to renegotiate debt, or you know, forestall, or refund or something. But you just want to be around, and this could be a bumpy road, but I think that, net, it’s a good road for exactly the reason you said. We have not experienced, in most markets, true economic growth. We’ve only experienced recovery.
MONTESI: There’s still real pent-up demand throughout the economy.
LINNEMAN: Huge! And housing has been the center of it all. But when I say housing’s at the center, remember what it means for your centers, yeah, it’s the house that sold, but it’s the guy who was laying the bricks, and the guy who was delivering the bricks that now have money, and there are now nine more guys hired to deliver bricks, and put in foundations.
MONTESI: Home furnishings too. Peter, I’ve got two more questions. My next question is, where do you see the opportunities in retail investment and development?
LINNEMAN: There’s nothing different in development than there’s ever been. Namely, it’s never been a spec business at its best, right? It’s always been, can I identify a site, and get the approvals, and line up the tenants for a non-spec product. And if you can, that’s always been and always will be a productive business because it’s real value add. You found a site and the site works, and you got the approvals for the upgrade of transportation and so forth. The only thing I would say in that regard is, the guys who have gotten in trouble on the development side historically either got in trouble on leverage, or they got in trouble in that they let the credit quality of the tenant slip, or they did it with too much spec space and less pre-leasing.
MONTESI: Yeah. We’ve lived some of that, and we’ve avoided some of that based on those reasons.
LINNEMAN: Basically I would say, if you did it unlevered, and if you always did it with 85% occupancy, you could probably count on two hands the numbers of people who got crushed, if you could really deliver the titlements and the road improvements, etc. Yeah, there has been some cost overrun. It’s a value creating business if you can execute. So on the development side, I really don’t think much is new, better or worse, in terms of the opportunities, because it’s not a spec business.
MONTESI: What about investing our new fund?
LINNEMAN: Investing a new fund. Avoid guys who have $500 million or more. That’s the simple “go where they’re not.” Because if you go with guys with $300 to $500 million to invest, they’re all going to the same places, they’re all going to the same product, and they all want the same assets. This is unrelated, but it’s related – I’m looking at apartments in eastern Ohio, because nobody with $500 million or more of capital is looking there. But there are people, and there are buildings, and they’re not going to go anywhere. By the way, they may not grow a lot, but I can underwrite not growing a lot. But right now, I don’t want to compete against people who have $500 million.
MONTESI: Yeah, that’s one of the things we’re planning to do. And the other one is to team up with those people with our co-invest fund, sort of let them win, and then they invite us in as operating partners.
LINNEMAN: That’s a different discussion. In fact, that’s the other thing I am doing. If I’m willing to take the kind of return they’re willing to take, then fine. Team up with them, don’t try to outbid them.
LINNEMAN: I’m not big enough to go do it, and you guys aren’t either. You’re big enough to do things well, but not big enough to outbid guys with lots of money.
MONTESI: Yeah, no doubt. So the next question is, I know you have a lot of relationships and clients that are institutions. The institutional folks, the sovereign wealth funds, you talk to them. So let’s just say the institutional investment market – what are you hearing from them? How can a quality retail operating company serve them? What can we do to make money serving those people going forward, that we might not have thought about?
LINNEMAN: In retail, those guys right now either want Shorthills Mall, they want what Taubman owns, or the equivalent kind of assets. And the closer they can get to those assets, the better, and they want urban, urban, urban, urban. Urban is the theme of the day. They don’t want lifestyle, in the sense of these lifestyle centers, necessarily. They want just urban. It doesn’t even matter if it’s right or wrong. That’s a second question. But, they’ve all bought that the millenials are all going to live in the cities, they all want small apartments, but they all want to go out and have a great time. They all are going to eat endlessly and drink endlessly, and party, and so forth. They all have this very Manhattanized stereotype. So, urban urban urban urban urban. It’s kind of stunning, to the extent that they want that. I’ve had conversations with some institutions who have basically said, I don’t want anything in the suburbs. Suburbs are dead. And I say, you know, if you look at the data, the suburbs are still growing faster than the city in terms of the population. And they’ll go, yeah but what about the millenials? They’ll give you all this stuff. So help them find really good urban opportunities. Real urban. Or build it.
MONTESI: So, anything we haven’t talked about that a quality operating company, investor, and developer that does the type of product types that I’ve described to you should be thinking about? You think we’ve covered it?
LINNEMAN: I’ll give you one other. It’s very market specific, which is, are there town centers – as you know, there’s the whole generation that got built, and as you know, most of them have struggled. And the question is on the ones that are struggling – I don’t have the answer, I know the question. The question is, of those that are struggling, is there an alternative retail configuration that works? That is, as you know, in many cases the site was pretty good, but the product was not – Borders is gone, for example, and you can go right through it.
MONTESI: We’re on it. I can name three or four that we’re still following, been looking at, some we’ve backed off from, some we didn’t buy that some other people have bought and things have gone well for them. But that’s great. That’s great advice.
LINNEMAN: If you can figure it out, there’s going to be opportunities available for you, that’s all the point is right?
MONTESI: That’s right. Thank you for your time.
LINNEMAN: My pleasure and always a pleasure.
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