Bill Ackman: The Real Estate Market is "Falling Off a Cliff"

I do think the economy is weakening, and I have some concerns. Billionaire investor Bill Amman just issued a dire warning message on the future of the real estate market and economy. Amman is the founder and CEO of Pershing Square, one of the most well-respected firms on Wall Street. That is why it got my attention hearing Amman warn about how it is highly likely that there is a tsunami of real estate bankruptcies on the horizon that is just about to make landfall. These bankruptcies have the potential to account for hundreds of billions of dollars and send massive ripples through the economy.

Let's hear what Amman had to say: "There's a general consensus in the United States, in some circles, that we probably have avoided a recession for the near future. We're going to have a so-called soft landing. That's the consensus. Is that your view as well?"

"I think it's really hard to predict. I do think the economy is weakening. We're seeing evidence of that in some of our companies. I have some concerns. You know, there's been a huge subsidy in terms of low interest rates, and most companies fix their rates or their debt at very low rates, and certainly, real estate investors did the same. That works until it doesn't work. What’s going to be interesting is to see what happens when people have to repay their debt. I think that can have sort of a cliff-like effect, and you're certainly seeing that in real estate."

Unlike most residential mortgages, interest rates on commercial real estate loans do not remain the same for the entire length of the loan. Here in the US, when an individual or family purchases a house, the vast majority of the time that purchase is financed with the standard 30-year fixed-rate mortgage. With a fixed-rate mortgage, the interest rate on the loan is fixed, meaning it doesn’t change for the entire time that loan is outstanding. This concept is incredibly important to understand and helps put Amman's warning into context. Since the interest rate never changes, the homeowner knows that their mortgage payment is going to remain exactly the same for as long as they own the house, or of course, until they pay off the loan in full.

Homeowners with fixed-rate mortgages don't have to worry about their mortgage payment doubling or even tripling due to interest rates spiking. This is a big reason why foreclosures on mortgages have been so rare. In 2021, only one-tenth of 1% of homes in the US were in foreclosure. Even during the worst period of the Great Recession, that number was only 2%—just a fraction of the default rate of other loans, such as credit cards and auto loans. US homeowners are truly fortunate that fixed-rate mortgages exist.

Owners of commercial properties are not as lucky. Unlike residential mortgages, commercial property loans are not fixed for the entirety of the loan. Instead, the interest rate on commercial loans resets every few years. While this may not sound like a huge deal, the impacts of these interest rate resets can be truly devastating, and that’s not an exaggeration.

Here's an example to demonstrate: Meet John. John had been saving his income for years and years and finally decided to buy a small apartment building as an investment. Let’s say this building costs $1 million. Like most real estate owners, John didn't have the entire purchase price of the property in cash just sitting in his bank account. As a result, John had to take out a loan to finance the purchase. He put $200,000 down and borrowed the remaining $800,000 from the bank.

The ultimate success of this investment for John is dependent on many things, but one of the most important is the interest rate on the loan. In this example, let’s say John got an interest-only loan at 3%. This means that each year, John, as the owner, is responsible for paying 3% 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 this 3% rate, the annual debt payment to the bank is $24,000. These debt payments are paid by the property's net operating income, or NOI for short.

Think of NOI as the profit of the property, excluding debt payments. The calculation is super simple: just take the rent the property generates and subtract out any expenses associated with owning, maintaining, and managing the building. Let’s say in our example this piece of real estate generates $50,000 in net operating income a year. As we can see, this property has more than enough NOI to cover the $24,000 yearly debt payment.

However, let’s see what happens as the interest rate increases. If we bump the interest rate in this example from 3% to 6%, the annual debt payment increases to $48,000. The NOI on John's building still covers the debt payment, but things are definitely more shaky. If we take our interest rate up to 9%, the property is now suddenly losing money. The annual interest payment is now a whopping $72,000 a year—well above the $50,000 the building is generating in income.

The owner, John, has one of two options: John can either come up with the money to pay the difference, or if he's unable to do this, the bank will take over the property through a foreclosure—often at a massive loss for both John and the bank. While this example here is of course oversimplified, it is symbolic of the massive challenge facing the real estate market.

There is an estimated $1.5 trillion worth of these commercial real estate loans coming due between now and 2025. This is the hypothetical cliff the real estate market is heading towards that Amman is referring to. For background, Bill Amman runs one of the most prestigious hedge funds in the entire world—Pershing Square. Pershing Square oversees a whopping $10 billion in investor money, generating likely hundreds of millions in management fees for Amman.

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Now back to the video. We talked earlier about how Amman is worried the real estate market is heading for a cliff. However, whether the real estate market falls off this cliff depends mostly on just one thing, according to Amman. Listen to him explain: "Now the markets are assuming, and the markets are not always right, but the markets are assuming that there's going to be a Fed discount cut sometime next year. As we talk now, just about the end of November, it's not clear what the Fed will do, but some people say that the Fed, if they were to cut interest rates next year, would help the Democrats and therefore be seen as very political. On the other hand, some people say the Fed can't wait until after the election because the economy might need a stimulus."

"So you have a view on what the Fed's likely to do?"

"I think they're going to cut rates, and I think they're going to cut rates sooner than people expect because what's happening is the real rate of interest, ultimately, which is what impacts the economy, keeps increasing as inflation declines. If the Fed keeps rates in the sort of middle fives, and inflation is trending below 3%, that's a very high real rate of interest, and I think that is having a sort of retarding effect on the economy. And then, of course, again, many businesses and certainly many individuals have the benefit of fixed-rate debt, and that fixed-rate debt certainly for companies and for commercial real estate starts to roll off. So I think there's a risk of a hard landing if the Fed doesn't start cutting rates, you know, pretty soon."

So, you know, I think the market expects sometime in the middle of next year. I think it's more likely probably as early as Q1.

In the US, interest rates spent the better part of the last 15 years at or near 0%. During that time, businesses and real estate investors loaded up on cheap debt that is about to come due. We've already talked about over $1.5 trillion worth of commercial real estate loans that are coming due in the next few years. However, that only tells part of the story. The world's largest companies are facing a similar challenge. According to Morgan Stanley, there is an estimated nearly $2.6 trillion in corporate debt coming due over the next 3 years. That breaks down to $770 billion in 2024 and $900 billion in both 2025 and 2026.

Okay, so you may be asking yourself why this matters. Surely, the world's largest companies have the ability to pay off their debts when they come due. Well, believe it or not, the vast majority of times that isn’t actually the case. I'm going to let you in on a little secret: when large corporations have debt come due, they rarely have the means to be able to pay it off with cash. Instead, they just issue a new loan and use the money from that new loan to pay off the loan that is about to come due. This concept is referred to as rolling over debt, and this wasn't really a problem when interest rates remained at low levels.

However, now the situation is massively different. Companies will be replacing old debt with incredibly low interest rates with new debt that has a significantly higher interest rate. While this may sound like just a small inconvenience, the impacts of this debt repricing will surely send ripple effects throughout the economy. Let’s use the iconic company Coca-Cola as an example. As of its most recent earnings release, Coca-Cola had $34 billion of long-term debt outstanding.

To show why higher interest rates matter, let’s do a simple thought experiment. Just for the sake of argument, let's say that Coca-Cola has a 3% interest rate on this $34 billion of debt. This means that every year Coca-Cola has to pay roughly $1 billion in interest. Now again, just for the sake of argument, let’s see what happens if we raise that interest rate to 8%. The annual interest expense now jumps to $2.7 billion—a staggering, roughly $1.7 billion increase. This higher interest expense comes directly out of Coca-Cola’s bottom line, making them less profitable.

It's more than just the shareholders of Coca-Cola that are impacted. In our example here, Coca-Cola now has $1.7 billion less dollars available that can be used for things that would grow the business—think actions such as hiring new employees, developing new products, and spending more money on advertising. Coca-Cola pulling back on spending would obviously negatively impact the economy. Coca-Cola is a stable blue-chip company; I think it's safe to say that Coca-Cola will be just fine in the long run. However, many other companies aren't quite as fortunate.

It is estimated that roughly 10% of US publicly traded companies are what is referred to as zombie companies—these are heavily indebted companies that are barely getting by, just making enough money to cover their debts, but that's about it. These zombie companies simply can't afford to see their interest payments increase at all, let alone double or even triple. If interest rates remain high and these companies are forced to roll over their debt, there will likely be a tsunami of corporate bankruptcies, obviously with devastating effects on the economy.

This is why, according to Amman, the Fed has no choice but to lower interest rates if it wants to avoid a painful recession. If interest rates remain high, it's only a matter of time until the real estate market and economy fall off the proverbial cliff. However, it’s not all doom and gloom. Though, this hard landing is far from a guarantee. There is a very real possibility that interest rates start to come down soon, and real estate investors and businesses are able to avoid having to refinance debt at these high interest rates. Only time will tell, but one thing is for certain: we are living in truly unprecedented times.

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.