Warren Buffett: "A Storm is Brewing" in the Real Estate Market

But it all has consequences, and I think we're—well, we are starting to see the consequences of billionaire investor Warren Buffett's warning about a major storm that is about to strike the US real estate market. This $1.4 trillion debt-fueled tsunami has already started to hit the real estate market as we speak. However, this is just the beginning of the quote consequences Buffett sees of this real estate bubble. The real impact is set to start in just a few months.

Here's what Buffett had to say: Uh, this question comes from Tom Seymour. He says, "The first sentence of a recent Financial Times article read, 'Charlie Munger has warned of a brewing storm in the US commercial property market, with American banks full of what he said were bad loans as property prices fall.' Please elaborate on what's going on in commercial real estate. How bad will the losses be, and what sectors or geographies look particularly bad?" I'll just add an addendum from another viewer who wrote in and wanted to know if Berkshire would be more active in commercial real estate as a result.

Well, B's never been very active in commercial real estate. It works better for taxable investors than it does for corporations. So, I don't anticipate huge effects on Berkshire, but I do think that the hollowing out of the downtowns in the United States and elsewhere in the world is going to be quite significant and quite unpleasant. I think the country will get through it all right, but, as they say, it will often involve a different set of owners. Yeah, the buildings don't go away, but the owners do.

Over the last 15 years, the US real estate market has been fueled by massive amounts of cheap debt. Take a look at this chart of the US federal funds effective rate, a proxy for interest rates in the economy. We can see here that interest rates spent the better part of the last 15 years at 0%. These low interest rates incentivized the use of massive amounts of debt and pushed real estate values to sky-high levels.

Imagine someone is buying an office building in your hometown for a nice round number—let's say the cost of this building is $1 million. The buyer of this building likely doesn't have an extra million dollars of cash sitting in his bank account to purchase this building outright. Likely, what this buyer is going to do is go to a bank to get a loan to fund the majority of the purchase price. In this example, our buyer here is contributing $350,000 of the purchase in the form of what is referred to as equity. Think of this as just a fancy word for down payment, like when someone is purchasing a house.

Our buyer then goes to a small local bank to get a loan for the remaining $650,000. How profitable this purchase is for the buyer is dependent on many things, but one of the most important is the interest rate on the loan. In this example, let's say our buyer got an interest-only loan at 5%. This means that each year, our buyer is responsible for paying 5% of the total loan amount in interest payments to the bank. Think of this as the equivalent of a mortgage payment for a homeowner.

At a 5% interest rate, the annual debt payment to the bank is $32,500. Whether the property can support that debt payment is dependent on the so-called net operating income of the property. Think of this as simply the rent the property generates minus any expenses associated with the ownership and management of the property. In our example, let's say the office building generates $660,000 a year in income for the owner.

As we can see here, this property has enough income to comfortably cover the debt payment. One important metric banks look at when evaluating whether to lend on a property like this is called a debt service coverage ratio, or DSCR for short. Think of this as a measure of how much breathing room a property has to be able to make its debt payment in the event things take a turn for the worse. This metric is calculated by taking the income the property generates—in our case, the $660,000—and dividing that by the annual debt payment—in this example, the $32,500—which leaves us with a DSR of 1.85.

As a general rule of thumb, banks like to see a DSR of greater than 1.2 times. At an interest rate of 5% and with a net operating income of $660,000, this property passes that test with flying colors. This low interest rate made the purchase of this property very profitable for our buyer here, even though the majority of the purchase was funded with debt from a bank.

However, let's see what happens when interest rates rise in the US. When someone buys a house to live in, the vast majority of the time that purchase is funded with a 30-year fixed-rate mortgage. With this so-called fixed rate, the interest rate remains the same for the entire time the loan is outstanding. This significantly reduces the risk to the buyer, as they don't have to worry about the interest rate on their loan increasing and causing their monthly payment to skyrocket.

Buyers of commercial properties, like the office building in our example here, are not so fortunate. Interest rates on commercial loans are not fixed for the duration of the loan. Instead, the loan essentially comes due every 3 to 5 years, and the rate resets to whatever the current interest rate is for that type of loan. While this may not sound like much at first, the result of these interest rate resets can be devastating for commercial property owners.

Let's go back to our example of the $1 million office building. Let's take the interest rate of the loan from 5% to 7%. This higher interest rate causes the annual debt payment to jump from $32,500 all the way to $45,500. The financial situation of this property just got a little bit more difficult because of the significantly higher debt payment. However, assuming the income the property generates remains the same, the owner is going to be okay, as the income still covers the debt payment.

Let's take things one step further and bump that interest rate up to 9%. The debt payment on this building skyrockets to $58,500. The $660,000 of income is barely enough to cover the debt payment. However, keep in mind this is an office building. The rise of remote work has significantly decreased the demand for office space, likely permanently. Let's say the income of this property falls from $660,000 down to $40,000 as tenants don't renew their leases and the amount of empty office space in the building increases.

The owner of this building is in big trouble now. The income the property generates is not enough to cover the debt payment. As a result, this property is likely headed to foreclosure. The bank is going to take possession of this building and sell it to a different owner, likely for a fraction of what the previous buyer paid. Ultimately, the bank will be forced to eat the loss on this loan. This is exactly what Buffett meant when he said the buildings don't go away, but the owners do.

Here's Buffett describing how the real estate market got into this mess in the first place: "Most people like to buy with non-recourse in real estate. One time I asked Charlie—I mean, there was some real estate guy we were talking to, and you know, how do they decide how much they can borrow? A building like this is worth. And the answer is, it's whatever they can borrow without signing their name. If you look at real estate generally, you'll understand what the phenomena that's happening, if you remind yourself that that's the attitude of most people that have become big in the real estate business."

And it does mean then the lenders are the ones that get the property. And, of course, they don't want the property usually, so the real estate operator counts on negotiating with them. And the banks tend to extend and pretend, and there's all kinds of activities that arise out of commercial real estate development, which occurs on a big scale. But it all has consequences, and I think we're about—well, we are starting to see the consequences of people who could borrow at 2.5% find out it doesn't work at current rates, and they hand it back to somebody that gave them all the money they needed to build it.

When you borrow money to buy a house to live in, you have to sign what is known as a personal guarantee. In short, what this means is that you are on the hook to pay back the bank regardless of what happens to the house. So, for example, if you have a $400,000 mortgage and the value of the house falls to $300,000, you are on the hook for the difference. You can't just give the bank the keys and say good luck, since there is a personal guarantee associated with the mortgage. The bank will force you to make up the difference, or you will have to file for bankruptcy.

Now, with that background, you would think that things would work in a similar way for commercial real estate. However, that is not the case. Typically, large commercial properties like office buildings, apartment complexes, and warehouses are purchased with what is called non-recourse debt. Here's how it works: let's say a large real estate investment firm buys a piece of real estate for $50 million. The real estate investment firm contributes $10 million and borrows the other $40 million needed to purchase the property from a bank in the form of non-recourse debt.

A few years pass by, and since this is a commercial real estate loan, it is time for the interest rate to reset. Unfortunately, this property was purchased at the peak of the market when interest rates were low and real estate values were sky-high. When it comes time for the loan to reset, the property is now only worth $30 million. Since this is a non-recourse loan, the owner of the property can toss the keys back to the bank and walk away. Yes, the large real estate investment firm loses the $10 million they put in to buy the property. However, now the bank is left with a property that is worth less than the amount they loaned.

Given that this loan is non-recourse, the bank has no option but to just eat the loss. This isn't just a hypothetical example. There is an estimated $1.4 trillion worth of these loans coming due over the next 12 to 24 months. Many of these properties are simply not worth anywhere near what they were bought for years ago, or the property can't sustain the larger debt payments from higher interest rates. As a result, a significant percentage of these properties will end up in foreclosure when the debt comes due.

We're already starting to see the beginning of this play out. Starwood, one of the largest real estate investment firms in the world, recently defaulted on a $212 million loan on an office building in the city of Atlanta. This office building was once a premier piece of real estate in a major rapidly growing US city. Currently, the office building is only 60% full, down from 90% when the loan was originally made back in 2018. The property had lost so much value that Starwood didn't even try to negotiate a deal with the lender to save it. Instead, Starwood, in fact, just handed the lender the keys to the building and walked away.

This may be one of the first of these stories, but I can guarantee there will be many more to come. The impacts of these defaults will likely be long-lasting and spread far beyond just the commercial real estate market. You see, the American banking industry is dominated by large banks. As this table shows, the six largest US banks have combined assets of a whopping $14 trillion. Naturally, given their massive size, it would be logical to assume that these large banks dominate the market for real estate loans. Well, surprisingly, that's not the case.

Believe it or not, the majority of commercial real estate loans are made by small regional and community banks. It's estimated that these small banks make roughly two-thirds of all commercial real estate loans. What this means is that it won't be large Wall Street banks feeling the pain from that storm that's hitting the real estate market. Instead, it will be the small banks that have made the majority of commercial real estate loans that will be left holding the bag.

Now, this is not a call to rush and pull your money out of your account if you bank with one of these small banks. The majority of these banks will be able to withstand these losses. Additionally, any banks that do fail will see depositors covered by FDIC insurance. Instead, the fallout will be much more subtle.

Here's why: in addition to doing the majority of commercial real estate lending, these small banks also dominate banking for small and medium-sized businesses. While the big Wall Street banks focus on doing business with Fortune 500 companies, these small banks lend to primarily small and medium-sized businesses that drive the economy in many cities and towns. The small banks that will take losses from lending to commercial real estate will now likely have to pull back dramatically from lending in general.

This will greatly negatively impact small and medium-sized businesses' access to credit. Without access to this capital, it will be much more difficult for these businesses to expand and grow, and this will result in less hiring and less spending, which ultimately negatively impacts economic growth. Only time will tell how this all plays out in the real estate market. However, one thing is for certain: as Buffett's business partner Charlie Munger said earlier in this video, there's going to be a lot of pain. The question is, who will ultimately be the one to bear it?

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. [Music]