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Volume 19, Issue 1

Published since 2001 Spring 2019

The following is an excerpt from the Spring 2019 edition term interest rates continue to suppress single-family
of The Linneman Letter. housing starts, though rising rates have also caused
home buyers to temporarily pause. But rates at current
and notably higher levels have supported healthy
“ Consumption is the sole end and
purpose of all production; and the interest
housing markets in the past.

of the producer ought to be attended to, Single-Family Home Starts

only so far as it may be necessary for 2,000

promoting the consumer. ~ Adam Smith ” 1,500


Consumers Fuel the Economy 500

The recovery remains strong and has now lasted 39 0

quarters through the first quarter of 2019. In the past 1960 1970 1980 1990 2000 2010

two years, the U.S. economy has achieved what most

economists said was impossible (though we never did): figure 2
U.S. growth in excess of 2.2%. But the 3.1% growth
in 2018 is simply a return to the historical norm, all
Articles available in the complete version of The Linneman Letter.
due to closer-to-market interest rates, lower taxes, and To subscribe to The Linneman Letter, contact Doug Linneman at
reduced regulatory intrusions.
In the fourth quarter of 2018, the economy grew Table of Contents
by an annualized 2.6%. And this growth (or higher) Consumers Fuel the Economy
Canary Watch Box
will also occur in 2019 and into 2020. Per capita real
The Mysterious Case of the Missing Billions
GDP grew by nearly 2.4% in 2018. This growth is The Reality Versus Myths of Share Buybacks
causing state tax revenues to surge to all-time highs. The State of Disability Insurance
State spending is unfortunately rising commensurately, Automation: Who’s At Risk?
Real Estate Capital Markets
guaranteeing state budgetary shortfalls during the next Construction Cost Trends
downturn. States should be reducing outlays, cutting Boo! Don’t Be Afraid of China
taxes, and replenishing “rainy day” funds instead of Governing From Glass Houses
raising spending. But they never learn. Issues Trump Racism
Fishy Forecasts
Runaway federal spending is crowding out more The Ineffective EU
productive private borrowing. Artificially low short- The Linneman Letter Look-back: Maastricht Treaty Violations
The Carbon Emissions Race: EU vs. U.S.
U.S. Carbon Taxes Will Go Nowhere
Real GDP Growth Rate Housing Market Update
Quarterly Annualized Growth Office Market Outlook
Industrial Market Outlook
5 Multifamily Market Outlook
Retail Market Outlook

0 Hotel Market Outlook

Seniors Housing and Care Market Outlook
Pipeline Sensitivity Analysis
Vacancy/Occupancy and Absorption Projections
Office Market Close-up: Phoenix MSA............................ Available online
1984 1989 1994 1999 2004 2009 2014
Industrial Market Close-up: Seattle MSA......................... Available online
Multifamily Market Close-up: Detroit MSA.................... Available online
figure 1 Hotel Market Close-up: Orlando MSA............................. Available online

Robert Lynn
The Linneman Letter Robert Lynn
Volume 19, Issue 1 Spring 2019

Real Estate Capital Markets real estate debt, banks continue to expand their mort-
We are frequently asked where the real estate in- gage book by 4-5% year-over-year. In addition, CMBS
vestment opportunities will be during the next down issuance is a net positive source of real estate capital,
cycle. Our advice is to watch for opportunities in pub- while life companies and government-sponsored en-
lic markets rather than in the private markets which tities also (GSEs) continue to actively lend. All told,
defined the down cycles in the early 1990s and 2000s. despite negative flows to real estate mutual funds, we
A prevalence of public market opportunities character- expect that both the flow of funds to real estate and cap
ized the 2008-2010 downturn, and we believe this will rates will remain solid in 2019. In short, due to con-
again be the case. Our reasoning is that greed swings tinued capital flows and solid NOI growth, we expect
more rapidly to fear (and back again) in public mar- commercial real estate to perform well in 2019-2020,
kets. In addition, the more than $325 billion of global even as interest rates increase.
private equity dry powder, as reported by Prequin in We have said for several years that cap rates are
February 2019, will create fairly competitive bidding determined by the flow of funds rather than interest
for private assets even in the face of fear. So we sug- rates. This has proven to be true over the past three years,
gest that those hoping to prosper from deeply discount- with interest rates rising and falling with no identifiable
ed pricing during the next down cycle should start edu- impact on cap rates. A simple way to see why this is
cating themselves on REITs today so they are ready to the case is to realize that due to new developments
jump in when the time is right. over the next three years, the total stock of commercial
As we look forward, with the large excess reserves real estate will be about 6% higher than today. If this
of money center banks and the more than $325 billion 6% greater real estate stock competes for the same
in real estate private equity dry powder, we expect cap amount of capital deployed today, values will fall (i.e.,
rates to hold, even as rates rise. About 15-20% of this cap rates will rise). This will be true irrespective of
unspent committed equity capital for real estate is tar- interest rates. In contrast, if there is 25% more capital
geted for the U.S. As the main providers of commercial chasing just 6% more real estate, values will rise (cap

Global Dry Powder: 14

Cap Rate vs. 10-Year Treasury Rate
Closed-End Private Real Estate Funds 12
300 10

$ Billions

150 6

100 4
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018*
*Through Feb 2019 1982 1987 1992 1997 2002 2007 2012 2017
Source: BAS-ML, Prequin
NCREIF Transaction Cap Rate 10-Year Treasury Rate Source: NCREIF

figure 3 figure 5

Foreign Commercial Real Estate Investment in the U.S.: NOI Cap Rate Spreads over 10-Yr Treasury
Acquisitions vs. Dispositions 600 (18-month lag)
(Trailing 4-Quarters, Real - 2017 $) 400
Basis Points

$ Billions

-25 -800
-50 -1,000
2001 2003 2005 2007 2009 2011 2013 2015 2017 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016
Dispositions Acquisitions Source: RCA Apartment Industrial Office Retail

figure 4 figure 6

The Linneman Letter Robert Lynn
Volume 19, Issue 1 Spring 2019

rates fall), again irrespective of interest rates. And

Linneman Real Estate Index contrary to mythology, real estate equity returns have
historically been better during periods of rising interest
150 rates, partly because owners had locked in low long-
Index (4Q82 =100)

term fixed-rate debt, while enjoying increased incomes

from improved occupancies and higher rents.
50 The Linneman Real Estate Index (LREI) monitors
the supply of real estate capital, as proxied by the ag-
1952 1960 1968 1976 1984 1992 2000 2008 2016
gregate flow of commercial real estate debt (the nu-
merator), with the fundamental demand for space, as
figure 7 measured by nominal GDP (the denominator). Exclud-
ing the net real estate equity flows from the numerator

U.S. Commercial Real Estate Mortgage Flows Multifamily and Commercial Mortgages Outstanding
300 4,500
200 3,500

$ Billions
$ Billions

100 2,500
0 2,000
-100 1,000
-200 0
-300 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017

1980 1985 1990 1995 2000 2005 2010 2015 Commercial Multifamily

figure 8 figure 11

U.S. Multifamily Mortgage Flows Multifamily Mortgages Outstanding

1,500 (2016 $)
$ Billions

100 1,000
$ Billions


-50 0
1980 1985 1990 1995 2000 2005 2010 2015 1952 1960 1968 1976 1984 1992 2000 2008 2016

figure 9 figure 12

Commercial/Mulitfamily MBA Origination Index

(Index of New Loans Tied to Real Estate) Commercial Mortgages Outstanding
400 (2016 $)

300 4,000
$ Billions

200 3,000

2002 2004 2006 2008 2010 2012 2014 2016 2018
1952 1960 1968 1976 1984 1992 2000 2008 2016
Source: Mortgage Bankers Association

figure 10 figure 13

The Linneman Letter Robert Lynn
Volume 19, Issue 1 Spring 2019

modestly understates capital oversupply situations and 170 in 2009 and bottomed at 134 in 2014 (a 21% de-
overstates an undersupplied market. The LREI captures cline) as the Financial Crisis drove substantial delever-
whether debt for commercial real estate is growing aging of commercial real estate. But after five years
more quickly or slowly than the economy. When the of increased lending, the index rose to 147 through
index is rising (“easy money”), it means that mortgage year-end 2018. This is a 10.2% rise since the 2014 low.
debt available for commercial real estate is rising more But it is noteworthy that it was up 2.1% in 2016, 1.4%
rapidly than the economy, and it declines when money in 2017, and remained in 2018, indicating remarkable
is tight relative to economic growth. The index is set to lender discipline. That is, capital is flowing but not
100 in the base year of 1982. We remind readers that flooding. This is a relatively rare condition, particu-
our research indicates that this metric is the key deter- larly during a strong economy. This discipline is par-
minant of cap rates, with a 1,000-bp increase decreasing tially due to heightened regulatory scrutiny of banks
cap rates by 106 bps (a 15-25% value increase). and partially due to high construction costs limiting
The LREI proxies the availability of capital to a development.
very capital-intensive asset class. The LREI peaked at

About Dr. Peter Linneman

Dr. Linneman, who holds both Masters and Doctorate degrees in economics from the University of Chicago, is the
Principal of Linneman Associates. For nearly four decades, he has provided strategic and financial advice to leading
corporations. Through Linneman Associates, he provides strategic and M&A analysis, market studies, and feasibility
analysis to a number of leading U.S. and international companies. In addition, he serves as an advisor to and a board member
of several public and private firms.
Dr. Linneman is the author of the leading real estate finance textbook, Real Estate Finance and Investments: Risks and
Opportunities, now in its fourth edition. His teaching and research focuses on real estate and investment strategies, mergers
and acquisitions, and international markets. He has published over 100 articles during his career. He is widely recognized as
one of the leading strategic thinkers in the real estate industry, and was named among the top 30 “Most Influential People in
Real Estate” by Commercial Property Executive in 2013.
He also served as the Albert Sussman Professor of Real Estate, Finance, and Business and Public Policy at the Wharton
School of Business at the University of Pennsylvania until his retirement in 2011. A member of Wharton’s faculty since
1979, he served as the founding chairman of Wharton’s Real Estate Department and the Director of Wharton’s Zell-Lurie
Real Estate Center for 13 years. He is the founding co-editor of The Wharton Real Estate Review.

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