This morning I had the pleasure of hearing Dr. Peter Linneman speak at the NYU Schack Institute of Real Estate. For those of you in a masters of real estate program or an MBA program, you likely know him from his widely-used text book, Real Estate Finance and Investments: Risk and Opportunities (affiliate link). He also serves as a principal of Linneman Associates, professor of real estate finance at Wharton (also founder of the real estate program), and author of the widely read Linneman Letter (focusing on the macroeconomic factors effecting commercial real estate).
Dr. Linneman was a captivating speaker who took a very simplistic view of the real estate industry, explaining its success hinges on two major factors; the ability for the U.S. to recover the nearly 7.2 million lost jobs and the ability to restore consumer confidence. Now I’m not going to get into too much detail, but I want to cover some of the major points of the talk.
Job Loss
Over the past few years we’ve lost roughly 7.2 million jobs and Dr. Linneman anticipated that we’ll lose another 500,000 jobs this year, bringing the total to 7.7 million. To make those numbers real, imagine traveling 65 miles in any direction from New York City. Now, every single person who worked in that area no longer has a job…that’s what losing 7.7 million jobs is like. However, 7.7 million lost jobs doesn’t mean that 7.7 million people have been fired, rather job loss is accumulated by not replacing employees who leave for retirement, pregnancy, or to go back to school.
As you can imagine, that amount of job loss has a severe impact on building’s cash flows. Dr. Linneman explained that we cannot begin to think about development until those jobs are recovered. He predicted that the beginning of next year will be flat, but we’ll add 500,000 jobs by midsummer. It’ll take 3 years to get back to where we were.
Consumer Confidence
Dr. Linneman stressed however, that in order for job creation to occur, consumers must regain confidence. Without confidence, companies won’t grow, consumers won’t shop, and our economy won’t expand. The consumer confidence index currently stands at 53, for a recovery to occur the index must get back to the 90 range.
Capital Markets
In addition to the job loss issue, there is $1.2 trillion in loans maturing over the next 3 years consisting of $300 billion in CMBS, $100 billion from Life Insurance Companies, and $800 billion from small banks and financial institutions (note we’re talking in terms of trillions and billions here).
The $100 billion in loans from Life Insurance Companies consist of primarily high quality assets, with high quality sponsors, written 7-10 years ago at LTV’s of 60-65%. Therefore, despite the decreased cash flows, assets appreciated enough over the past 10 years and interest rates are low enough that these loans are in good shape.
The $300 billion in CMBS were primarily written between 1999-2001. The loans were not quite as high quality and consisted of a lot of hotels at LTV’s of 65%. Most of these loans will be okay with the exception of the hotels.
Of the $800 billion in loans held by banks, 42% are land loans that were written in 2004, 2005, 2006, and 2007. Of the approximately $350 billion (42% of $800), the banks will be forced to take $300 billion in write-downs, mostly by small banks that will ultimately go under. The FDIC will be forced to take over the small banks and liquidate the assets. The other $450 billion were loans written at the peak of the market. They were written with high LTV’s and unrealistic income projections. A lot of these loans are getting killed because the borrowers have fixed-rate interest charges, while others are hanging in there because they are tied to LIBOR which is virtually zero. Lenders continue to ‘extend and pretend’ these loans, but, ironically enough, they will blow up as the economy recovers. This will happen because interest rates will rise prior to cash flow increasing, resulting in borrowers being unable to cover mortgage payments.
Recovery
When the recovery inevitably takes place, Dr. Linneman noted the first sector to recover will be multi-family as the population continues to increase, yet supply remains stable. Next will be warehouses, as people will need a place to store their excess stuff. Next will be retail, as consumers regain confidence, and lastly office, as companies are forced to expand.
Dr. Linneman left the crowd with one last thought. In poker there are times when you can win with a pair of 6’s and there are times when you can lose with three Jack’s. Now, in real estate, you need three Jack’s to even have a chance of raising equity.
