Real Estate Finance And Investments Linneman

[Jules Altier]

Thischapter discusses topics which a real estate investor must consider when analyzing an investment. While building a financial pro forma is a necessary step, many of the underlying assumptions built into it will be wrong. Many factors beyond financial modeling, such as personal risk tolerance, competitive landscape, the capital market environment, among others play into the decision-making process.

Operating costs can easily be incorrectly forecasted. An increase in expenses will reduce net operating income. Unexpected changes in vacancy can have a large effect on the accuracy of a financial model as well. In a weak or over-supplied market, buildings may have occupancy well below expectations for long periods of time. Liquidity is another underlying risk as it takes a long time to sell a property, and sometimes an investor needs cash quickly. However, real estate also offers unexpected opportunities for investors. Just as operating costs can increase, they can also fall, rents can rise, and property values can appreciate. This chapter lays out some of the risks and opportunities an investor must consider when underwriting an asset.

Conducting market research can help to clarify the supply and demand balance within the market and is the backbone for assumptions made in the pro forma. In this chapter, the importance of conducting such research is reviewed, and examples of sources for information, and what to look for when researching a market are provided.

Finally, this chapter reviews how personal decisions play a role in choosing investments. Investment decisions ultimately depend on who the investor is, how risk-averse they are, and what expertise they bring to the table.

BRUCE KIRSCH: We have a special treat today. We have Wharton emeritus professor, Peter Linneman with us. And he is going to share some of his insights and experience and wisdom as it relates to topics that are addressed in his textbook, which is used at over 70 colleges and universities in the US and around the world. And so Peter, thank you very, very much for spending some time with us today, and for sharing your thoughts.

And the buildings existed, but they had nothing to do with them. This was straight out of like a movie, Right The whole exercise was simply to get you to go to a refundable deposit, and then the escrow agent, who worked for a major brokerage firm, so you kind of thought, well, that guy was bought off and the money disappeared.

And so I think that the way that you framed the rest of the textbook by opening it up in chapter 1 with these thoughts is terrific. And it sets the stage for people to understand the material for what it really is. And for the real stakes that are at play.

To put it another way, Geltner and Miller is used in B schools. Brueggeman and Fisher is used in undergrad courses and at graduate programs where the students do not all have a strong base in real estate finance. When I teach at Columbia, I use Brueggeman and Fisher as many of the students do not have a finance background. The program is housed in the School of Architecture for a reason.

For many years, I was on the faculty at the Wharton School of Business at the University of Pennsylvania, in the real estate, finance, and public policy departments. I did that for 34 years, and was part of creating the real estate program there. I'm still an emeritus member of the faculty, but not in any ongoing day-to-day sense.

I've had an advisory business, a boutique advisory business to private equity firms, to some public firms, to high wealth individuals. A few endowments that I've had, and the corporations that I've called Linneman Associates, which I've done since 1979.

I'd say today, 90 percent of what I do in that is commercial-real-estate focused. We also have an investing arm, which has bought some land, and some apartments, and some other things over the years; very boutique-y stuff, off the beaten ... Not off the beaten path, but not buying a giant shopping centers, not buying giant office buildings.

I have my book, which we're in, whatever, I think fifth edition, with Bruce Kirsch, called Real Estate Finance and Investments Risks and Opportunities, which is in use in the industry and in universities. I have a publication called Linneman Letter, which is a quarterly publication we've done for about 18 years. That's done by the same kind of client base I was referring to before - some institutions, some public companies, some private equity, some high wealth, et cetera.

There are really two parts to this. One is that ... I'll just take the US, but what I say applies to other economies. If you ask what commercial real estate does, it houses the US economy. The US economy generally grows 8 1/2 out of 10 years. Therefore, the demand generally grows about 8 1/2 out of 10 years, and a year and a half out of every 10 years, it goes a bit backwards; sometimes deeply, like the last ... Like the financial crisis, and more generally, in a more modest way.

You sort of suffer for a couple of years, and capital abandons you for a couple of years, which is very difficult, if you're a capital-intensive industry like real estate is. If you weather those couple of years where capital abandons you, fear beats out greed, the lack of capital, short term, dominates.

If you say, "But I'm in it for ..." and I'm just going to say the 10 years, the 10 years are basically going to have growth. Yes, you can find little pockets of the country that didn't grow, and yes, you can find segments that didn't fully recover, but you can also find those that more than fully recovered. You're betting, then, on this pattern of growth which has continued to occur.

The other thing you're betting on is supply doesn't go crazy. If you grow 10 percent, the economy grows 10 percent, but you add 100 percent to the real estate stock, that's going to be ... You don't have that much more economy to house.

As long as supply more or less grows at around the same rate as real economic activity, it kind of balances out. You don't do spectacular. It's not like you invented a new drug protocol, or a new technological something. You don't have much chance of a thousand fold your money.

On the other hand, as long as you can be in there, you don't have much chance of losing all your money. It turns out, and when you look at the data, as long as ... Where people get in trouble investing in real estate is two ways. One, they put on a lot of debt and take something that fundamentally is not all that risky, but when you put a lot of debt on it, the equity part gets risky. During that one-and-a-half/two years of down, you lose it. You just lose it.

If you look back, most of the people who got squeezed out of their properties during the various down periods, at least in my life, were right; they just were wrong in their capital structure. That is, they were right, it's a decent building in the long run. They were right that tenants are going to want to be there in the long run, but they weren't able to stick around, and find out they were right because they got foreclosed.

The other mistake that people have made ... I use mistake in that people are making these decisions with their eyes open. Why did they put on the debt? To juice the return, if they're right. The other is they adopt short hold periods. What's a short hold period? Two years, three years, four years. The problem is that what I just said is kind of accurate over a decade, but I don't know which year and a half is going to be the down year. I'd like to think I know, but you don't know which year.

If you go in with 10 years ... We've done a lot of work on 10-year holds, only because it's an easy thing to do. Ten years has a ring to it. You do okay. As I say, it's not like you invent high tech or something, but you do just fine. You do sort of ... Over a decade, even during the bad times, even if you bought at the peak, even if you sold into a period that was down, at the end of your 10-year hold, you're doing 8- to 10-percent annual return, typically; sometimes better, sometimes worse. Very seldom negative.

If you go in with a three-, or four-year hold, you're going to pick up that's sometimes, the time you "want to sell" is the time you either can't sell, or won't sell because it's the down period. You take the risk, but that risk comes at a price.

If you say, "Why does it tend to work in the long run?" It tends to work in the long run, if you think about it ... Just do a very simple cycle. Everything's in balance. Then, the economy goes down; demand falls. That's got to get sloppy, and people get fearful, and that hurts values even more. There was new supply that's finished, because it got started a year, or two earlier, and it finished during that, so it even got sloppier than just the demand fall. Then people panic.

Then, what happens is since it's so sloppy in the market, since values are down, everybody stops construction. It's self-adjusting, because if you don't build anything for three-four years, and after a year or two, growth starts again, the growth fills the empty space, and then gets a little ahead of the no building. Then, eventually, the supply catches up. When you look at it as a decade, it kind of balances out, but not in any window. The supply shutting down is the key, as long as the economy grows.

There are two data sources. One goes back, I believe it's to 1978 ... I'm doing that from memory. The other goes usefully back to about 1992. The first is on institutionally owned data that, or institutionally owned real estate. That reports to the National Council of Real Estate Investment Fiduciaries - NCREIF.

They've been around all these years collecting data. Your pension fund owns this big office building, and voluntarily they report income and values on a pretty regular basis. Is it 100-percent perfect data? No, but it's pretty good, and they take it seriously.

You can go back, I believe it's, to 1978, and what we did was simply say, "If I bought in '78 and sold in '88; if I bought in '79, sold in 89 ..." but just mechanically go through that, right, a 10-year hold. That means I can't say what happened - I bought in 2011, because 2021 hasn't occurred. On the other hand, you have 35 years or whatever it is. We did it by property categories, because they break it down by shopping centers ... We did it for [inaudible] did it for shopping centers, we did it for apartments, we did it for warehouses-, we did- multi-family...

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