Charlie Munger: The Real Estate Crash of a GENERATION

Billionaire investor Charlie Munger just issued a dire warning about what's ahead for the U.S. real estate market, and unlike most people who issue these types of predictions, Munger actually knows a thing or two about the topic. Before he rose to fame as the vice president of Berkshire Hathaway and Warren Buffett's right-hand man, Charlie was a real estate investor. In fact, Munger is still investing in real estate today. One firm that he invests in is one of the largest owners of apartment buildings in Southern California, which is why it got my attention when Munger warned about what is happening right now in the real estate market during a recent interview with the Financial Times. The impacts of which will be felt way beyond just real estate, sending ripple effects throughout the economy.

Using his words, there is a lot of agony and pain out there in the real estate market right now, and it's only about to get worse. Here's a little story to demonstrate what Munger is talking about. The Wall Street Journal recently did an investigative piece on a man named Jay Gajafelli. Gajafelli is what is referred to as a real estate syndicator. His business model is simple: he pulls together money from high-income or upper middle-class individuals. That pool of money is then used to go out and buy a piece of real estate. This syndicator then takes a large cut of the profits from the property, allowing him to make money without investing any of his own capital.

The story of Jay Gajafelli exemplifies what has been happening in the real estate market in recent years. Before Gajafelli started his real estate career, he was just another mid-level I.T. worker. However, last year his company owned more than 500 million dollars worth of apartment buildings, with over 7,000 units. He was even one of the largest landlords in Houston, Texas—no small feat considering Houston is the fourth largest city in the U.S. Gajafelli's investment strategy seemed fairly simple and straightforward at the surface. He would take money from investors, combine it with money borrowed from a bank, and buy what is referred to as distressed properties.

These are properties with a lot of empty units that need significant renovations to bring rental rates up to current market levels. While the strategy seemed low risk, there was one big issue: rising interest rates. Let me explain. These properties were not purchased with traditional mortgages, like people used to buy a house here in the United States. You can buy a house on a 30-year fixed-rate mortgage; with these fixed-rate mortgages, your interest rate is locked—AKA it doesn't move for the life of the loan. Instead, however, these apartment buildings were purchased with what are known as bridge loans. Bridge loans are short-term in nature, intended to be only used for the relatively short period of time in which the apartment building is being renovated and rents are being raised.

These bridge loans come with a feature that makes them incredibly high risk, and that feature is a so-called floating interest rate. As opposed to the traditional fixed-rate mortgage where the interest rate is the same for the life of the loan, with floating rate debt, the interest rate moves around to whatever the current interest rate is. This dynamic can cause large swings in how much the owner of the apartment building has to pay each month to cover his debt. Here are some numbers for you. Let's say one of these real estate syndicators takes out a 30 million dollar bridge loan to buy a large apartment building at a two percent interest rate. That means the owner would have to pay six hundred thousand dollars a year in interest to stay current on this interest-only loan. If that interest rate skyrockets to eight percent, his annual interest expense increases by a factor of four, all the way to 2.4 million dollars.

Imagine what would happen to the average American if their mortgage payment increased by four times in just a matter of months. They would be in financial distress pretty quickly. Meanwhile, the real estate syndicators that purchase property using floating rate debt aren't too much better off. Going back to our story about Jay Gajafelli, unfortunately for him and his investors, he purchased properties with floating rate debt. According to The Wall Street Journal in April of 2023, four of his apartment complexes with a combined 3,000 units fell into foreclosure. Investors in these properties were wiped out. This is one of the largest commercial real estate blow-ups since the great financial crisis. Gajafelli is just one of the thousands of these real estate entrepreneurs in the U.S. known as syndicators, many of whom have come under similar financial pressures and owned properties they can no longer afford.

So far, defaults have been rare, but according to Charlie Munger, it's just a matter of time until things spread even further. Here's what he had to say: "A lot of real estate isn't so good anymore. We have troubled office buildings, a lot of shopping centers, a lot of troubled other properties. There's a lot of agony out there." The agony from what is going on in the real estate market spreads way beyond just investors; banks are also going to get hit hard. In the Financial Times interview, Munger said that banks are full of these bad commercial property loans. In recent years, nearly all of the large banks significantly decreased their lending to real estate. Smaller regional banks and credit unions were there to fill the gap. Now the majority of lending in the real estate space is done by these smaller lenders.

These small lenders are the ones that are going to be left holding the bag when these properties have to be foreclosed. In the most simple terms, banks are in the business of lending money. At the surface, their business model seems pretty straightforward. Banks take in money in the form of deposits and then turn around and lend that money to people and businesses, the goal being to make a profit on the difference between what they pay their depositors and what they receive from lending the money out. If you've ever interacted with a bank, I'm sure you know this business model firsthand. You make a 0.1 percent interest rate on the money sitting in your checking account but have to pay seven or eight percent to borrow money from a bank. You don't have to be a genius to see how this business model can be extremely lucrative.

However, there is one underlying assumption embedded in the business model of a bank: that the people they lend the money to will actually pay them back. If not, the bank that gave the loan is forced to eat that loss. So going back to our example of a real estate syndicator, let's say a property was purchased at the peak of the market for 50 million dollars. That purchase being broken up into five million dollars in the form of equity from the investor and a 45 million dollar loan from the bank. The real estate investor had a plan to fix up the property and raise rents, ultimately resulting in the property being worth more. However, things went south quickly. Rising interest rates, construction costs, and declining property values caused the project to fail. As a result, the bank ended up having to take the property back as part of a foreclosure.

To understand who lost money in this part of the deal, you have to understand what is referred to in real estate and investing as a capital stack. A capital stack shows how a purchase was funded between a mix of debt and equity. Equity is just a fancy way to say the money that was contributed by the owners to help fund the deal; debt is money that the owners borrow from a lender and are contractually obligated to pay back. Those at the bottom of the capital stack are the ones that would have to get paid back first in the event of a bankruptcy or foreclosure. Because of this dynamic, the lower you are on the capital stack, the less risk you're taking. This is why 12 to 18 months ago, banks were lending money for two to three percent; banks are almost always at the very bottom of the capital stack. They are taking the least risk and therefore receive the lowest return.

But on the other hand, equity investors are taking more risk by being at the top of the capital stack. Equity investors need to receive a higher theoretical return in order to assume that higher amount of risk. The simplest example of this capital stack concept is someone buying a house for them and their family to live in. Let's use John here in this example. John is buying a house for one hundred thousand dollars, and yes, before I get absolutely roasted in the comments, I know there's virtually nowhere in America where you can buy a house for that little. I just needed a nice round number to keep the example and math simple. John put a 20 percent down payment to make this purchase. This twenty thousand dollars represents the equity portion of the capital stack of this purchase.

In order to get the rest of the money needed to purchase the house, John goes to his local bank to get a loan. The bank gives John a loan for the remaining eighty thousand dollars needed for the purchase. John now has the entire one hundred thousand dollars and can buy the house. Let's take a look at the capital stack for this transaction. Twenty percent of this purchase was funded through equity, eighty percent through debt. John's equity sits on top of the bank's debt in the capital stack. In investing lingo, the bank's debt is senior to John's equity. This means that if something goes wrong, the bank has to get paid back in full before John even receives a penny. To demonstrate what I mean, here's an analogy using two empty glasses and a pitcher full of water. On the left, we have the money that the bank has owed; on the right, we have John's equity. The water in the pitcher represents the proceeds from selling the house. If John fails to make payments, the bank's cup has to be filled up completely before John's equity cup receives even one single drop of water. If there isn't enough water to fill up the bank's cup completely, John's equity cup is going to be dry.

Let's put some numbers behind this theoretical example. If the house is sold tomorrow for 90,000, the first eighty thousand dollars would go to the bank to make them whole, the remaining ten thousand dollars would go to John. If the house is sold for eighty thousand dollars, there would be just enough money for the bank to be paid back in full, but John would be left with nothing. But what happens if things go really bad? What if the real estate market crashes and the house John paid one hundred thousand dollars for is now worth just fifty thousand? This is where things start to get nasty for the bank. The bank takes a pretty significant loss of thirty thousand dollars. The bank lost represents nearly forty percent of the amount of the loan. This thirty thousand dollar loss represents a drop in the bucket for the bank of any significant size, but when you get into the world of commercial real estate that Charlie Munger is warning about, the numbers get big and they get big quickly.

What if instead of a thirty thousand dollar loss on a small single-family house, it was a 30 million dollar loss on a foreclosure of a large apartment complex or office tower? All it takes is just a handful of these types of losses until the regional and community banks that have come to dominate the real estate lending market start to feel the pain. In his interview with the Financial Times on the topic, Munger said, "Trouble happens in banking just like trouble happens elsewhere. In the good times, you get into bad habits. When bad times come, they lose too much." Many banks and real estate investors got into bad habits in the boom times of recent years. Properties were purchased with large amounts of debt at sky-high prices. Investors and banks were relying on aggressive assumptions and strong economic times in order for the deals to make sense.

We have already seen the bad habits, and now we're starting to see the repercussions. The fallout from banks losing money is going to have ripple effects beyond just Wall Street. As we can see from this graphic here, nearly 70 percent of all real estate loans are held by banks outside of the top 25 largest in the country. So it's not going to be JPMorgan Chase or Bank of America getting crushed from what's happening in the commercial real estate market. Instead, it's going to be the local community banks that are so important for cities and towns throughout the United States. These banks are absolutely critical to the economic development of the regions in which they operate.

When banks experience losses, it decreases their willingness and ability to lend money. This has ripple effects throughout an economy. Picture a small business owner in your hometown. This entrepreneur owns a pizza place on Main Street, and everyone in the area loves the pizza, and there's always a line out the door. Given the success this location is experiencing, our entrepreneur naturally wants to expand, so he picks another city just 45 minutes away from his original spot that would make a perfect second location. There's only one problem: the owner doesn't have all the money that is needed to open up the second location. There's a lot of things to pay for when opening up a restaurant: the down payment on the real estate, remodeling the building, purchasing equipment, buying inventory, paying workers to train them before the grand opening—the list goes on and on.

In order to open the second location, our business owner needs a loan from a bank. Given the relatively small size of this loan, he likely will go to a community bank or credit union. If the business owner gets approved for the loan, a lot of people are poised to benefit. First, there are all the new employees that will get hired at the second location. This new pizza shop opening up will create a lot of new jobs in the local economy. There are also all the contractors that will get paid to fix up the building in order to get it ready for the grand opening: plumbers, electricians, painters, handymen. This location opening will give all of those people more work, and it won't just be blue-collar workers benefiting. White-collar professions, such as real estate brokers, lawyers, and accountants, will all get more business as a result of this location being opened. Then there are all the companies that make the new equipment that will be used in the new restaurant: pizza ovens, pots, pans, silverware, tables, chairs—companies across the world would be supplying equipment needed to operate this restaurant. The list goes on and on, but you get the point. This restaurant opening is going to be a huge positive for the economy.

But what if the local community bank denies the loan? They deny the loan not because they don't believe in the entrepreneur or the business; the bank denies the loan because it took significant losses from bad real estate loans. All of the people and businesses that were poised to benefit from the restaurant opening are out of luck. While this is obviously a hypothetical example, there are hundreds of thousands of real-life situations just like this happening at any time in the United States. This shows how trouble in the real estate market can send shockwaves throughout the broader economy. Only time will tell if we see this dynamic playing out across the United States.

So there you have it. Thank you so much for watching. Make sure to hit that subscribe button because it's my goal to make you a better investor by studying the world's greatest investors. Talk to you again soon.