A Conversation with Peter Linneman
Larry Jacobson: As we underwrite deals, we are encountering, what strikes us as quixotic rent growth assumptions. And, it's conceivable that we're just the old ladies. It's conceivable that we're the ones that are being too conservative. Yet, you know, I don't think so. And, we try to revert to the mean on our long term rent growth assumptions.
Obviously, we feel like, OK, we can get confident in the first couple of years. We can look at what the market's done. We can look at supply/ demand fundamentals. We can look at the employment situation. But, when you wrote about the golden, or you spoke about the golden era of multifamily, we thought that was very compelling and we did speak to our investors about it.
The reason I was fascinated with what you had written is, and the reason I wrote about it, was to sort of encourage people to start rethinking - what do they need out of a real estate investment in terms of the delta between what you can get in a value-add apartment complex versus a obviously the risk free, the risk free rate. But, I guess the question I would have for you, obviously, if things have changed right now, prices have gone up considerably. Interest rates have gone up as well.
At what point does that not apply? At what point do you say, this is not where we want to be.
Dr. Peter Linneman: So that "golden moment", for lack of a better that I wrote about. Which, if you recall, it was so obvious by the math. Right. That -.
Larry Jacobson: Absolutely.
Dr. Peter Linneman: And it was. It was the confluence of where cap rates were and where interest rates were and where rental growth, kind of, was going to be. Which was not spectacular. If you looked at what I wrote, it wasn't like I thought rental growth is double digit. It was going to be solid over a 7-10 year period, but it was the financing versus purchasing.
Now, that has narrowed a bit. How much is a bit? Probably 100 bps - 100 basis points - that gap has narrowed and I think it's taken it from a truly golden moment. That is, if you could have bought at that moment, done what I said, locked it in, blah, blah, I think you had a golden. You're still in a good moment. It's not a golden moment, but it's a good moment. You say how? It seems like underwriting is pretty close to perfection. And what I'm going to talk about is 7, 10 year holds. I'm not going to talk about 2-year flips and... because that's much more about timing and so forth. Right?
So, I'm willing to bet, you, like everyone else, you were mentioning a deal in Salt Lake City or someplace, you hope to get right. I'm willing to bet - I haven't seen your model. You've got, 7 years from now or 10 years from now when you exit. The exit cap is 50 basis points higher than your purchase, right? I haven't seen your model, but I know the model, right?
Larry Jacobson: Exactly what it is.
Dr. Peter Linneman: By the way, you and everyone else did that for the last decade and every year you were wrong. By the way, every year I was wrong. So, I'm not laying it off on - I'm just saying, every year, and yet we all keep doing the same thing. Okay? And then, we all keep saying, and it's priced to perfection and it turns out, it wasn't priced to perfection after all, with hindsight.
Right? With hindsight, at least so far, because cap rates either held or came down, as those moments came. And in light of that, it wasn't underwritten to perfection. Now, why do I say that? You hear a lot of discussion about inflation, inflation, inflation. The major inflation that occurred following the financial crisis was not of goods and service prices, it was of asset prices.
And the money came out to asset buyers who bought assets from asset owners who went out and bought other assets, who bought other assets for others. And so, by and large, the money put in during the financial crisis didn't come out for about 3 years. And then as it started coming out in '14, '15, '16 through '19, it chased assets. That's what they lent to, primarily.
And, you had a lot more money chasing assets than assets were being created. So gold prices went up. Stock prices went up. Private equity prices went up. Real estate, apartment homes. Some more than others. OK. We have jammed in (when I say "we" - the Fed) has jammed in a staggering amount more money during COVID, into the banking system. It is the same banking system that we know primarily lends to asset buyers. They are not pulling money from borrowers, but they're not pumping a lot of fresh money out. It's kind of neutral right now.
But, what about 2 years from now, or 3 years from now? I think you get a repeat of what we saw in '14, '15, '16, '17, '18, which is, a lot of money is going to come out chasing assets. The pricing of assets has been permanently changed by QE 123 and now QE infinity. We have put in amounts of money that a system has never had in it, and it largely is going to chase assets.
And so if you told me, what do you think I should underwrite for, 7 years from now, as my exit cap? I would tell you, 10% lower than you're going in at. 10% lower. So, if you're going in at a 4 1/2 cap, you're going to go out a 4.05 cap. I'm just doing fast, right? And then, by the way, you put some value-add on top of that. So, you took the 4 1/2 cap to a what? To a 5 and a 5-3, something like?
And, you're going to exit at a 4.05. Now, if I could guarantee you that's true, which I can't. But if I could guarantee you that's true, would you say you've underwritten to perfection? The answer is no.
Larry Jacobson: Not. Right.
Dr. Peter Linneman: Lots of room. Now, why do I say this - is because, there's a reason multiples have gone up for stocks. There's a reason the price of gold went up. There's a reason, there's a reason. And it's because there is untold amounts of money that have chased those assets based on QE1, QE2, QE3 lending and, not this year, not next year probably, but thereafter, QE infinity-driven lending. And when it does, I want to own the assets.
Now, I'm not saying the cap rate goes down by 50%. That's not what I'm suggesting. But, you can do a little "back of the envelope". It's not hard at all to say they stay and it's not very hard to say they go down by 10% or so. And there is - I think it's one of the most important pieces of research I've done. And by the way, research doesn't ever definitively prove something, right? It identifies something. And that's this research and we had it in the last issue or two issues ago, that cap rates are not driven by interest rates. Statistically, they're driven by flow of funds.
Now, you know that. You know that, in your business career, cap rates are low when there's a lot of money chasing stuff and they're high when there's no money chasing it. And it doesn't matter a lot about interest rates. And, I just think you're going to have a lot of money chasing it because the Fed put the money in the system.
They do not want asset prices to fall. So, if you put a lot of money in the system, premised on asset prices never fall. When it comes out, it's got to go up. And yes, you'll get NOI growth. That'll be good, right? I'm not saying you won't NOI growth. But, you still have - not quite as mathematically golden, as I wrote.
But I still think it's a great era because only an asset that can cash-flow. So, you do what we were just saying. I don't know - a 4 1/2 cap. So you're not buying the best vests in Santa Monica, right? But, a 4 1/2 cap is not ridiculous. You value add it up to 5.4. You finance it at what - a 3.2?
Larry Jacobson: Yeah. It's in the range.
Dr. Peter Linneman: Something like that? You put 70% debt on. Your coverage is amazing, right? Just mathematically. So you're not going to lose it even if income takes the short term hit. Your coverage is great. Your cash flow is - you have real cash flow. You actually have real cash flow.
And, you still have residual and the residual you own is biased to cap rate going down, not up. That's how I view it and apartments are particularly attractive, less because of the supply/demand fundamentals, which are OK. There's nothing wrong with the supply/demand. But, because it's the deepest capital pool out there. It's all the institutional money. It's all the individual money. It's all the bank money. It's all the life company monies and, Fannie and Freddie.
And so, it becomes the deepest capital pool in a world where I won a deep capital pool on exit - whenever that moment comes. So, that's how I view it. On its fundamentals - I guess industrial is better because every shirt sold online takes 3 X the warehouse space as a shirt sold in a store. So, when you say, how much the growth of online sales is and you say, what's that mean for warehouse needs? It means you've got to add about 4% new warehouse stock every year.
And we're only adding like 2 1/2 - 3. So, if you look at it as a - supply/demand fundamentals. Probably warehouse is the best, at least for a while. But the capital market part is not as good. If you had Freddie and Fannie, in the warehouse space on top of what's already there - you know, it becomes a much, much deeper capital pool.
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