We are in the "First Inning" of the Real Estate Crash - Billionaire Real Estate Investor

So, we've seen discounts already of, let's say, 10-15%. Are we going to see discounts of 50%? Are we going to see buildings just turned over to the banks? I mean, what does it look like in terms of the bottom for this market? Billionaire real estate investor Jeff Green is warning that the problems facing the U.S. real estate market are just the beginning. In his words, we are only in the quote "first inning" of this downturn.

Green is one of the most successful real estate investors ever, with a net worth of a staggering $7.5 billion, which is why it got my attention when, in a recent interview, he went as far as to say that certain pockets of the real estate market will soon become completely worthless. Here's what he had to say.

Next guest is one of the giants in Florida real estate, not to mention a big set of holdings in LA and New York. We've been focusing a lot on that sector lately. From sky-high interest rates to the reluctance of employees to return to their office, joining us now is billionaire investor Jeff Green.

"Jeff, it's great to see you. Welcome. Good morning, Robert."

"So, you were famous for predicting the housing crash in 2008. You bet against that, made a lot of money from that trade. I want to talk about commercial real estate. You have a lot of commercial real estate, especially in Florida. You've got a couple of towers going up there, I think over 200,000 square feet, that's going to come online. What do you think the commercial real estate market looks like, not just in Florida, but nationwide?"

"Well, those towers actually total over a million square feet. Just the office space alone is 200,000 square feet, right? Look, I think commercial office space globally is going to go through a major change. What we've seen during the pandemic is, you know, people have adapted to a different work style where they can use Zoom and Teams and other methods to get the same amount of work done than they used to do going to an office. So, there's no question that there'll be less demand for office space going forward. Couple that with the fact that we've just had an economy with trillions and trillions of dollars injected into it, which has really caused a lot more demand than we would normally have for office space. So, now that's being pulled back, and that, coupled with the way people work, is going to cause, you know, a contraction in demand."

"Yeah, and how bad will that contraction be? I was talking to a family office yesterday that said they had been offered a couple of big trophy office buildings in Manhattan, but they said the prices just weren't low enough for them to bite yet. How bad is it going to get with commercial real estate, and where are we in terms of the cycle of discounting or maybe even opportunities?"

"I think we're just in the first inning of this correction, Robert. I hate to say it, but, I mean, basically, you've got to understand that at the end of the pandemic, which wasn't that long ago, there was an extra $2.1 trillion in people's savings accounts. That’s extra $2.21 trillion in March; it was $500 billion, now it's $190 billion. As that disappears and completely evaporates from people's bank accounts—all that money—there's going to be a lot less money to spend. So, what's that going to mean for demand for everything—retail, office, apartments? Every aspect of real estate is going to get whacked, and I think we're just in the first inning."

"As far as the trophy properties go, of course, they're not getting heavily discounted; they probably never will. Look, I understand it's Warren Buffett's birthday, happy birthday, Warren! But I can quote Warren, and one of the greatest things he ever said that I heard was always: it's better to buy a great company or great property at a fair price than a fair property at a great price. So, those great trophy properties, they probably haven't come down a lot, and they probably won't come down a lot. If somebody's goal is to accumulate and acquire, you know, world-class assets, they need to buy them sometimes when they just come down a little bit. But I think when it comes to the B and C properties, the worst is yet to come."

Real estate prices are determined by an economic concept known as supply and demand. We can demonstrate the concept using this graph. Here on this line, we have the demand for that price of real estate within a certain market. Think of this as the number of people or businesses that want to rent or buy that particular type of property, and on this line here, we have supply. Think of this as the amount of that type of real estate available in the market. The point at which these two lines cross is the price for that real estate.

To demonstrate supply and demand in action, let's use an area of the real estate market that is extremely topical right now: commercial office buildings. Prior to 2020, the demand for commercial office space had been increasing at a relatively constant rate for decades. Of course, things could fluctuate in any given year based on the health of the economy; however, the long-term trend was that more office space was needed. This was really driven by two major factors.

The first is the growth of the working-age population in the United States. The working-age population of a country is a very close proxy to the size of that country's workforce. As we can see in this chart, the size of the U.S. working-age population increased from 135 million in the 1970s to approaching nearly 210 million at the start of 2020. Put another way, more workers called for more space for these people to perform their jobs.

At the same time, with each passing decade, a larger percentage of these workers had jobs that took place in an office setting. As we can see in this chart, as the United States became less and less of a manufacturing-focused economy, a growing percentage of Americans had a so-called white-collar office job. These two megatrends resulted in a decades-long run of strong growth in demand for office space.

Going back to our supply and demand graph, this ever-increasing demand pushed our demand line to the right, ultimately putting upward pressure on office building rents. At the same time, the supply of office buildings was not able to fully keep up with this growing demand, and a lot of that had to do with the geography of many major cities. Let's use New York City as an example.

New York is considered the financial center of the world and is home to many large, prominent companies. Prior to 2020, as these New York-based companies grew, they naturally needed more and more office space. The most desirable locations for this office space were in this area outlined on the map. However, there was a major problem: Manhattan is literally an island. There is only so much land in this highlighted area, and nearly all of it already had existing buildings.

If an office developer wanted to build a new office tower, it usually meant tearing down an existing building and building something new in its place—an extremely costly and time-intensive process. This dynamic made it very difficult for new supply to be added to the New York office market. Going to our supply and demand graph, supply would increase over the years, but not nearly enough to keep up with demand. This is why office buildings in cities like New York were considered some of the absolute safest real estate investments in the world.

But oh boy, do things change. The rise of remote work has fundamentally altered the supply and demand equation. Companies simply do not need anywhere close to the amount of office space they once did, and this has caused the demand line here to dramatically shift back to the left—likely permanently.

Now there is simply too much supply relative to the demand. This is reflected in sky-high vacancy rates. New York City has office vacancy rates of nearly 17%, multiples higher than pre-2020 levels. While the commercial real estate market is already facing massive challenges, this may just be the beginning.

So, we've seen discounts already of, let's say, 10-15%. Are we going to see discounts of 50%? Are we going to see buildings just turned over to the banks? I mean, what does it look like in terms of the bottom for this market?

"Well, look, when it comes to some of these office buildings and in markets where there were just no tenants, I think there'll be no bids. I think it's going to be at the point of time of, look, when I—after I did the subprime trade, I went back in and was trying—was buying some of the mortgage-backed securities, and I was getting 22% and 30% yields on conservative assumptions. I think you're going to see the same thing will happen in the retail and commercial sector because there will just be office buildings with no tenants whatsoever in markets where brand new buildings, like the one we're building at West Palm Beach, will get the tenants because we'll be the new tallest building in Palm Beach County with all kinds of great amenities. Some of the older buildings just won't have any tenants at all, and if there's no tenants at all for a prolonged period of time, that paper will be worth next to nothing."

"But, you know, again for repurposing—there will be value there. So, I would say, you know, hold on to your cash and get ready because there'll be some—my guess is in the next, you know, 12 to 24 months, you're going to see some extraordinary opportunities to buy."

Not all commercial real estate is going to be impacted the same. Let me explain. A commercial property can be classified in one of three categories depending on things such as the building's age, location, quality and amenities. These properties are thus rated as A, B or C class, with A being the best and C being the worst. Many of the problems in commercial real estate are really concentrated in these C-class buildings.

I'll even use my hometown as an example. In the city where I grew up, there is a massive shopping mall that was built in the 1970s before the rise of online shopping. This mall was considered a prime piece of real estate. It was full of retail tenants that were household names: stores like Macy's, J.C. Penney, and Sears. However, as the internet changed how people shop, this mall became less and less relevant. One by one, stores within the mall started to close down as people did more shopping online.

Not wanting to throw good money after bad, the owners stopped investing in maintaining the building. Eventually, the property got so dilapidated that no high-quality businesses wanted to be located in it. This piece of real estate is now a shell of its former self and is definitely a C-class property.

On the other hand, a few miles away, there is a newer commercial property. This property was built five or so years ago and has a large newly remodeled grocery store as one of the tenants. Additionally, it is filled with national brands including TJ Maxx, Starbucks, and Chipotle, as well as popular local shops and restaurants. This piece of real estate is always buzzing with people. The location, quality, and caliber of tenants make this a Class A commercial property.

While this example of the contrast between Class A and Class C properties is from my hometown, I know there are countless other stories just like this throughout the entire country. While this video has up until this point focused on what is happening in the commercial real estate market, it is important to note that residential real estate is facing its own set of challenges.

Here is what Green had to say: "I'm surprised, Jeff, to hear you say that you think residential is going to get whacked as well. You have about over 8,500 residential units between LA, New York, Florida, New England. One of your properties in Manhattan just rented for $125,000 a month. And we have record rents here in Manhattan because there's no inventory on the sales side. What's going to bring the residential side down, and why are you pessimistic about residential real estate?"

"Look, Robert, in Manhattan it's a unique market. I mean, there's no question that in Manhattan, I mean, there are people that make millions of dollars a year. They have private equity companies where they're getting fees, and so if they need an apartment, some of those people can afford the guy who paid $125,000 a month for the apartment in the building you're showing on the screen—you know, is in the crypto world. So, you know, they have easy money that they're spending. But in the real world for most Americans, you know, what’s happened is the wages have gone up a lot. Because we've had a booming economy, we own hotels in Palm Beach, we've had to pay our chefs who were making $16, $18 an hour before the pandemic at after—during the after the pandemic—and they were making $26 now, with signing bonuses. Well, all of that happened because of the trillions and trillions of dollars that was thrown into the economy. As that goes away you're going to have unemployment, you're going to have people making less money, and these high rents."

"The other thing that's happened, certainly in Florida—which is where we have the biggest position, and again I want you to know, I mean I'm the biggest believer in West Palm Beach and Palm Beach County—we probably are the biggest investor. But I can tell you the demand that we've seen there is a direct function of what happened during the pandemic. As everyone knows, the feeder cities to South Florida—New York, Boston, Philadelphia, Washington D.C.—those cities had to close down during the pandemic. Because they were, people have to ride subways and live close together in high-rise buildings, a lot of people from those cities were going to Florida. A lot of them. And what happened is anyone who was going to go to Florida into 2022 or 23 or 24, 25 or 26—they all said, you know what, we can't go to work in New York or Boston anyway! I can get my job down on Teams or Zoom or whatever. Let's move now."

"So, we borrowed a huge amount of demand from the future. Remember, the calculation was easy too. You could sell your home outside of Boston or in Greenwich at a high price as people flock to the suburb during the pandemic."

"So, you think that migration is over between the Northeast and Florida, or certainly is largely done?"

"Absolutely. Because, again, people could take and sell that house in Greenwich and buy a house in West Palm Beach with a 3% loan. Now they have to sell the house in Greenwich with a 3% loan and buy one in West Palm Beach with a 7% loan. So, of course, it’s going to—it’s long-term. I love South Florida for the next few years; it's going to be very tough, and we’re very overbuilt."

Home prices across the United States have absolutely skyrocketed in recent years. The median price of a home in the U.S. has increased from $322,000 in the second quarter of 2020 all the way to a high of nearly $480,000 at the end of 2022. Certain parts of the country saw prices rise significantly more. As we can see in this map here, the areas that saw the highest price increases were cities and states people were flocking to—places such as Las Vegas, Arizona, Texas, Tennessee, Georgia, and the Carolinas.

However, arguably no real estate market has boomed as much in recent years as Florida. Using the city of Tampa as an example, home values have essentially doubled since 2019. In 2019, the median Tampa house was selling for a little over $200,000; now that same house would cost nearly $400,000. This has many people calling Florida the epicenter of the U.S. housing market bubble.

Ultimately, what happens in the housing market will be determined largely by interest rates. We talked earlier about how real estate prices are determined by supply and demand. Well, the demand side of the equation is heavily influenced by interest rates. Let me explain. The majority of houses in the U.S. are purchased using a loan, the standard loan product being the 30-year fixed-rate mortgage. A bank loans a home buyer money, and the buyer agrees to pay the bank a monthly payment every month for 30 years.

The size of that monthly mortgage payment depends in large part on what interest rates are at the time of purchase. Here are some crazy numbers for you. Let's say our home buyer here takes out a $400,000 loan to purchase a house at a 2% interest rate. His monthly mortgage payment would be $1,478. At a 4% rate, the payment would increase to $1,910. If we bump the rate up to 6%, that payment rises to $2,398. Ouch! Let's take it up another notch and raise the interest rate to 8%. Our buyer's monthly payment skyrockets all the way to $2,935.

Our buyer's monthly payment has increased by 99% solely due to the higher interest rate. Notice how the payment is double even though the price of the house and the size of the loan remain exactly the same. This is what Green meant when he said higher interest rates are negatively impacting demand.

The concern is that these higher interest rates, coupled with new supply getting added to the market, will start to put significant downward pressure on house prices, particularly in markets that skyrocketed in recent years. Ultimately, only time will tell how things will play out. However, it is worth listening to Green and what he has to say. I mean, after all, he does know a thing or $7.5 billion about what he's talking about.

So, there we have it. Make sure to subscribe to the channel because it's my goal to make you a better investor by studying the world's greatest investors. Talk to you again soon!