Peter Linneman on Real Estate: The Storm Is Over, the Wreckage RemainsPublished: August 19, 2009 in Knowledge@Wharton
Although some upbeat economic news in recent weeks might indicate the beginning of the end of the recession, there's still plenty of "wreckage" to deal with, says Wharton real estate professor Peter D. Linneman. Nowhere is this more apparent than in the housing and commercial property sectors, which have taken one of their worst beatings ever. Linneman refutes the argument that the U. S. government should do more to prop up the weakest parts of the economy, like the troubled real estate industry. In an interview with Knowledge@Wharton, he also draws on policy missteps of the past to caution the Obama administration to tread carefully and avoid "trying to cure things they can't cure," while contending that the U. S. might have more in common with countries like Venezuela, Russia and Japan than most observers think.
An edited transcript of the conversation follows.
Knowledge@Wharton: Could we start by taking stock of the real estate market -- both housing and commercial. What does it look like to you today and for the rest of the year?
Peter D. Linneman: Let's take housing first. Single-family housing starts have bottomed and will slowly pick up.... For the last four months, single-family housing prices at multiple listing services -- namely what real people are selling their homes at instead of foreclosure sales -- have been up in almost every market except Las Vegas. So that part is positive, absent further economic collapse driven by Washington.
The multi-family side has fallen off a cliff. Multi-family starts are about a quarter of their historic norm. They're down 75% in about seven months as a run rate and they'll stay down because of the shortage of available construction capital. It's not such a horrible thing because there's a fair amount of vacancy. What's happened is that as the economy has lost jobs, people have doubled up. Young graduates stay with their parents; immigrants stay with their cousins and brothers. That will continue until the economy improves, which probably won't be until late this year and into next -- again, if Washington can just keep calm. Therefore, the lack of construction going on is a good thing in the sense that it means you can eat up excess inventory. It's not good if you're in the construction business, but as a general matter it's good. The multi-family [sector] won't pick back up until next year, based on my analysis.
If you ask, is the storm over? The storm is over. What's left is cleaning up the wreckage from the storm. People have a hard time distinguishing the storm and the wreckage. [There is a] big difference though. When that hurricane is still hitting you, it's still creating more damage. Now what you're dealing with on the housing side is all of these people who bought speculative homes. They thought prices would only go up. They thought they'd flip them in six months. There was nobody to flip them to, so of course, they foreclosed. They had no money in it. They didn't lose anything. That's probably over half a million homes.
So the wreckage is still being dealt with -- [by] the people who were speculators, the people who bought 97%-loan homes even if they were living in them and [the people in] greater Ohio. Greater Ohio is, say, Ohio and 50 miles [just outside] of the Ohio border. That's in a real recession. It's been in a real recession for seven years. That's a different issue than the rest of the country faces.
Unfortunately, the government is trying to cure things it can't cure. The government is trying to [give] what is not theirs to give. Salvation is not theirs to give, but they're trying to give salvation. If you had no money in your home, and you thought you would flip it in six months for 100% profit -- and then prices fell 20% -- salvation [for that business decision] is not the government's to give. They shouldn't do it. And the more they try to do it, the more harm than good they're doing.
Knowledge@Wharton: When you say the storm is over and what's left is the cleanup, is that just in the U.S. or do you see the same thing internationally?
Linneman: That's fairly true everywhere. The difference is on the commercial side. It's true everywhere with the minor exception of China and Brazil, and the very minor exception of India. And when I say that [I mean conditions are] good for Brazil, China and possibly India.
Knowledge@Wharton: How do you see the differences between the way the financial crisis affected the housing market and the commercial market?
Linneman: In one sense, it's totally different; in another, it's not. The way [the commercial market] is different [is that] it wasn't subprime. The Fed kept interest rates at effectively 1% for four years while inflation was running at 2.5%. It guaranteed that anybody who put their money short and safe, lost money for four years. Well, people aren't going to sit around and lose money for four years. People piled into long and risky.
The common element is what was long and risky. Subprime was long and risky. Certain types of commercial real estate were long and risky. Condominium developments were long and risky, not just in the U.S. Developments in [India] were long and risky. Leveraged buyouts of operating companies were long and risky. The common element was long and risky [assets], not real estate.
If you look across the world, anything that was long and risky has been crushed because the government went from forcing people artificially to demand long and risky to quite the opposite. It forced them to demand short and safe. Demand changed dramatically, from being artificially high to [becoming] artificially low. The government also encouraged [buyers] with low interest rates ... [making it enticing to borrow] short and float.
People are looking at the symptoms rather than the cause. The cause was low interest rates forcing people to go long and risky. Better to lose money later with a risk than for sure now. It turns out now is the settling up for when you went long and risky.
There's no similarity between a home [loan] and a commercial real estate [loan]. Commercial real estate has a cash flow behind it. It has tenants behind it, everybody from the U.S. government to a venture capital firm. [Residential] homes have you and me [asking], do we want to stay here? [There is] no cash flow. By the way, the leverage was much higher on the single-family side at the margin. People forget that 20% of all homeowners have no mortgage -- no mortgage -- in the United States.... Only 5% of all Americans are not current with a mortgage, 33% of Americans rent, 20% have no mortgage and 5% aren't paying [their mortgage].
Knowledge@Wharton: Coming back to the role of the government, you said earlier that it shouldn't try to do what it can't do. What is the right strategy for the government now?
Linneman: My view is that [what] government [officials] should have done but didn't [was to] admit that they are also human beings. Milton Friedman was a professor of mine and he used to say that when you listen to people talk about the government, if you change the word government to omnipotent deity, the meaning of most sentences would be unchanged. You hear people say the government should help delinquent borrowers. What they really are saying is an omnipotent deity should come in and save them. They're just human beings. They have no more information than we do. They have no more expertise than we do. They have powers of mandatory behavior, which are dangerous because I make mistakes everyday at my job. For all we know, this tape is not working. Well, if this tape is not working and it's just us, it affects two of us. If we've committed a similar mistake and we're in charge of the government, it affects 300 million people.
What they [the government] need to do is admit they're human, and that they do not have answers. The phrase I've used throughout all this is, first, do no harm. We've had a government that for the last year has -- under both the Bush administration with Paulson and the Obama administration with Geithner -- leaped, then looked. They leap to grand solutions, whether it's TARP or TALF ... then two days later they say, "Well, we're not going to do it that way and by the way we're changing.” All [I see that] they've done is obliterate rules.
The thing that distinguishes us from Zimbabwe, Russia and Venezuela, is that prior to September 1, 2008, you had a fair idea that if a company couldn't pay its debts, it would go into bankruptcy and the process would work out. You had a fair idea that if a bank couldn't collect its loans, it would be taken over by the FDIC and liquidated.... Now they're talking about oil. Will we regulate oil prices? On and on, so that you have no certainty at all.
What was the best way to raise money prior to September 1 last year? You went to Wall Street. You made a pitch to investors and you tried to convince them. What's the best way to make money today? Lose a lot of money and then go to Washington with your political power and try to raise money. That can't be good because I don't know who is politically powerful enough. So they've ruined the playing field. People do not play games if they don't know the rules. That's why Zimbabwe, Venezuela and Russia have weaker economies -- nobody knows the rules. I don't even have to like the rules. You and I play games all the time that we think have stupid rules. But as long as we know the rules, we'll play.
We changed from the most predictable rules in the world to [a] Russia-Venezuela [approach]. If you don't believe it, suppose I told you the Duma in Russia conducted hearings for two weeks on whether to subsidize, to the tune of tens of billions of dollars, a couple of companies? After two weeks they said no. The next day Putin said yes. You'd say, "Well, that's Russia. And that's why I don't invest in Russia.”
That's literally what happened in November to the auto industry. Congress conducted hearings. They said no. Twelve hours later, the Secretary of the Treasury said, "We'll do it anyway."
I'm not picking on Democrats or Republicans. Unfortunately, this has crossed party lines. What they really need to do is -- less. Unfortunately, that is not what they're good at.
Knowledge@Wharton: Let's look back about 20 years [when] the savings and loan debacle happened. The government agency called in the Resolution Trust Corporation, or RTC, to solve, at that time, what looked like a big mess, and Wall Street, securitization and real estate investment trusts [REITS] emerged as a solution. As this scenario plays out with real estate finance, and housing and commercial real estate, where do you see the sources of capital [coming from] and what will the landscape look like?
Linneman: There is a great similarity between what happened then and [what is] happening now.... One, human nature. Human nature then said things only go up and we believed our own [lies]. One of the things that happens at the end of every cycle, by the way, is that human nature takes over, so it's not the first time human nature has taken over.... You're not going to regulate human nature out of existence. Madoff is not the first guy to steal. Wars have been going on since the dawn of man. Murder has been going on. And so have economic ups and downs because of the hubris of people.
The difference was the government then said, "We are going to live by the rules. If you're not solvent, we're going to shut you down.” Did they make some mistakes in hindsight of shutting down a few people who were solvent? Yes. And the courts later resolved that. There were so many of them that were insolvent, they had to liquidate them and set up a special agency.
Instead of doing that this time, the government has said, "We can decide how to keep people alive.” Instead of shutting down the insolvent, they've kept the insolvent [institutions] alive and pumped in billions of dollars. Think about it. There's only so much money and capital in the system. If you give money to insolvent people, all you're guaranteeing is that the solvent aren't getting the money. There's only so much. My analogy is that if you give blood transfusions to the dead, they're not only not going to get up and dance the jig, but there won't be any blood to give to those who are still alive and could benefit from it. That was the big mistake we made this time.
You mentioned securitization. Securitization came to the rescue of Latin American debt if you think about it. Back with the Brady bonds, it came to the rescue of the S&L crisis -- namely, we'll package stuff up both in terms of debt and equity. The equity side has proven pretty successful. Yes, the stock prices fell. Hey, stock prices of everything fell. REITS stock prices fell more than the prices of other stocks for one simple reason -- that in normal times, they have a beta of about 0.5. They aren't perfectly correlated. Therefore, people are willing to pay a premium for something that's not perfectly correlated. When people rush for the fire escape, everything is perfectly correlated. Not only does it go down as much as everything else, no longer are you getting a premium for the fact it doesn't. It actually has to fall more. The flip side is going to be ... it will go back up more until the next time we rush to the fire escape. And we will rush to the fire escape again within the next 10 years because we're human.
How will capital sources come? They will be equity, not debt. It will, in the near term, be a massive debt-for-equity swap. People say we're over-levered.... At the face value of the debt we are, but not at the current market valuation. It's a little like saying I put $100 million into my stocks. Of course, they're worth $20 million today and you're still saying, "No, they're worth $100 million.” No they aren't. They're worth $20 million. In the same sense, if you look at the market value of the debt, whether you trace it through the banks, through what's traded or through [commercial mortgage-backed securities or residential mortgage-backed securities], we're not over-levered.
What we are is over-face valued, which means -- because debt is a contract -- you've got a lot of contracts that have to be worked out. Whereas equity says no workouts; it's just down. It's great for lawyers, bad for everybody else. Where will the money come from? It will come from public capital markets first. The REITS are in the best position to take advantage of this because they're around, they're loaded, they're low leverage, they're transparent and they're name brands. The private equity funds will take advantage of it. It's more difficult because they've told investors that they are going to get 20% to 25% returns. It's very hard to make a pro forma show of 20% to 25% return on a cash stream -- any cash stream -- without a lot of leverage. So the absence of leverage means you can get 12%, 15%, 18% on paper, but not [in the 20% range]. And that's a challenge for private equity.
... You'll probably see some private equity funds go public, for example, [and] use that money to pay down debt ... and restructure in that way....
You are going to see banks sell assets. It's going to go a lot slower than people think because this time the U.S. government is acting much more like Japan did in the early 1990s, which was very slow to shut down the insolvent [Japanese banks]. We are giving blood to the dead, rather than giving blood to the living. If we do that, they have less incentive to [sell] assets, create a market and move on.
Knowledge@Wharton: What will real estate look like and what should it look like in the future?
Linneman: What it will look like in the future is pretty obvious -- ups and downs, with more up than down. Probably 60% to 70% up and 30% down -- but the downs occurring right when you think they're impossible to occur and the ups occurring just when you think they'll never occur. As I was saying to some friends at a gathering that I host of major real estate people, if you go back to 1997, before the Russian ruble crisis, nobody saw the extent of the collapse.... At the height of the dot-com, nobody saw that two years later you'd be in the depths of 9/11. You may have seen a down, but not the depths. In the depths of post 9/11, nobody saw 2005 being as strong as it was. As you sat in 2005, nobody saw the first quarter of 2007 being as frothy as it was. In the first quarter of 2007, no one saw the depths we're in now.
Why do you believe any of us when we sit here and say anything, because even those of us who have been pretty good at predicting, have only predicted direction and generally missed magnitude. I predicted a recession five years ago and every quarter thereafter for 2009. So great, I was right. I predicted flat GDP and a 1.5 million job losses. I was only off by 4.5 million jobs and I was only off by 6% of GDP. Other than that, I was a genius, right? The point being, even those of us who got directions right, missed magnitude.
We need to have some humility and understanding. We're going to be very wrong about the next two years. The next two years are going to see a lot of asset price appreciation, particularly related to real estate. You're going to see better economic performance than people are foreseeing. If you look at past recessions, that's always turned out to be the case.
The real estate industry [is] probably going to have a great four years for public companies, including companies that aren't ... [yet] public. You're going to see a number of private equity funds struggle, some [just] to stay in existence [because of their debt]. Let's face it. Anybody who used debt is caught up in that negotiation game. And if all your energies are caught in the negotiation, you're not in the create-new-value game. You only have so much time and energy. Those who had low debt --a few families but mostly public companies -- will have the opposite [experience].
Will securitization arise? Some version of it, yes. Do I know exactly what version? No.... What you'll see is that securitization is not going to go away. People are saying, "We should do this regulation or we should not allow this or not allow that.” Trust me. If you read the literature that people -- intelligent people doing thoughtful analysis -- wrote as securitization was occurring, not just in real estate, it said, "Look at all the problems it's solving. Yes, it does have a few drawbacks, but...” Well, as things gain momentum, the "buts" come to dominate the benefits. In the beginning, it's easy to get the benefits to dominate the "buts. "As we push things and we start believing our own [public relations] and our hubris sets in, we push the margins....
There is a myth [that] securitization created this problem. It's not true. What created the problem was bad risk analysis, whether it was bad risk analysis on the equity side or bad risk analysis on the debt side. A loan to somebody to flip an apartment when there are 50 apartments that [are ready to move into] and there are 500 [apartments] being delivered in a year -- if you give 100% loan on that, that's a bad loan because it was badly underwritten, whether it's securitized or held as private loan, or even if it's bought with 100% equity. It's bad risk analysis. Fifty are needed. And 500 are being built. That's ten years' worth. If you're pouring money into that, that's bad....
Bad risk analysis generally goes with either the end of a cycle -- when we start believing ourselves -- or bad policy. The bad policy was the 1% interest rate, which made things look better than they should have as an alternative.
By the way, do I think the Fed will never make another monetary policy mistake? It was an honest mistake. It certainly wasn't a dishonest mistake. Of course, they're going to make more mistakes because they're just human beings. So securitization isn't what is wrong. Japan, in the 1980s, made the greatest number of insane loans with the worst risk analysis and the worst documentation in modern history. None of them were securitized. They were all held on balance sheets.... The packaging of it influences it at the margin. But bad decisions are bad decisions, no matter how you package them.
Knowledge@Wharton: The argument that some people might have is that with securitization you don't have to hold the risk. You can move it to somebody else.
Linneman: The old joke was -- this is in the old loan world when you didn't securitize -- I make the loan and then if it doesn't work, I pretend it's good until either I get promoted or retire. Right? That was it. So the institution in some sense held it. But when you get to where the rubber meets the road, it's human beings. And human beings have the incentive to not take the responsibility for their own mistakes. We have the human being dimension to take all the responsibility for any success we're remotely [close to], including success we have nothing to do with. Failure [has] no parents and success [has] a thousand fathers. These are old sayings for a reason. When [these loans] were held as whole loans, or when they were done as equity, dot-com had relatively little debt, was some of the worst risk analysis ever. Hundreds of billions of dollars [were] wasted on bad risk analysis.
By the way, if we had done it as debt rather than equity, would it have been any smarter if we'd have held them as whole loans rather than equity. Dumb is dumb as [far as] risk analysis [goes]. And the packaging can influence [the risk profile], but it's secondary. The truth is, you saw relatively few people with 100% of their own money making really dumb decisions -- in any of these. What you always see is a lot of people, with other people's money [making bad decisions], and an incentive structure [to further encourage those decisions].
Because we're human beings with flawed integrity and the ability to tell ourselves we're doing the right things even when we're not, one of our greatest abilities is deluding ourselves. I look in the mirror every morning and I see John Wayne at his best. It gets me through the day. You see the storybook here. We all delude [ourselves]. People are focusing on the package it [these loans] came in. I've got bad incentives whether I'm holding the loans on and I'm trying to get my bonus that year or I'm trying to sell them and get my bonus. It may be more transparent one way over the other.
Securitization made the problem visible about two years earlier than it did in Japan when it was private, and than it did in the S&Ls when it was behind closed doors. I shudder to think how big the mistakes would have grown to if they had have been behind closed doors instead of securitized.
Knowledge@Wharton: What are the main lessons that we should learn from this experience?
Linneman: Great lessons. One: Whenever there's more money being offered to you than you can imagine, it will be followed by a period where nobody's going to offer you money. Another lesson: Don't match long assets with short liabilities. These aren't rocket-science lessons, but they are lessons.
Third: Debt has risk. Normally, and too often, people only think debt has a price, but not a risk. A lot of people say, "Debt is cheaper than equity.” Do you understand how many people paid as the cost of their debt -- not the interest rate -- they paid all their equity. I put in 20% equity on a purchase. The interest rate was 4%. It ended up costing me one year of 4% interest and 20%. It cost me 100% of my equity.... The biggest risk of debt is not that the interest rate goes up. The biggest risk of debt has always been -- I wrote this in my book years ago -- [that] they don't want to give you money when your debt is due.... This is not the first time it's happened. It's interesting. I'm 58 and in the last 31 years I counted five times when economic events that supposedly only happen once every 100 years have occurred. Must have been a good 31 years, you know?
This stuff happens and it happens because we're human. That's the last lesson. We are human. We don't need more regulations. We just need to enforce the regulations we have. We have regulations that date back to the 1930s that say no federally insured depository can exist unless it can demonstrate safety and soundness. And we pay regulators -- we have paid regulators -- to enforce that. I think they missed. I'm not even blaming them. Remember, the burden of proof is you don't get a government insured deposit license unless you can demonstrate safety and soundness. It's pretty obvious they weren't safe and sound. Again, they are human beings on the regulating side as well.
It reminds me of the tragedies of gun control. Every time somebody walks into a McDonald's, a post office or a school and kills ... people with a handgun, you know that the next day there will be cries for more gun control. Every state in the country has probably 14 inches of gun control laws because every time [new legislators are voted into office], they pass an addition. What we need to do is to enforce the gun control laws, which say children, criminals and the mentally unstable should not have access to them. All those laws already exist. Forget more regulation. Just enforce the ones we already have. All that more regulation can do ... is make it harder to enforce, because I am going to have to spend a year figuring out what they mean. Now instead of 14 inches, I have 28 inches of regulations and I can't pay attention to all of them.
Madoff is not a matter of market failure. Madoff is a matter of regulatory failure -- over four administrations. The guy was a thief. Do we need new laws against thieves? There have been laws against thieves as [long] as mankind [has had laws]. Yet there are always thieves. The issue is having the will to enforce what you have. It's rare that we're passing a law that is truly improving on the fundamentals of the Ten Commandments or the Koran or whatever. They figured it out then. Don't lie. Don't steal. Let's just have it real simple. What we need is a dedicated enforcement effort that takes it seriously. That's difficult to do because it takes a human will that's generally not there. We're not inventing anything new. We're just reliving. One hundred years from now this will all just be history. It's like reading about World War I. It happened over there, a whole bunch of people got hurt and some died. It was a great tragedy. But it will just be history. We're living history and it's just going to keep repeating itself in variations. At least that's my view.