Jamie Dimon: The “Crisis” Forming in the Real Estate Market

If rates go up and we have a recession, there will be real estate problems, and some banks will have a much bigger real estate problem than others. You're going to want to hear what Jamie Dimon has to say about the future of the real estate market and the economy. Dimon is the CEO of JP Morgan Chase, with $3.7 trillion of assets. JP Morgan is one of the largest and most powerful financial institutions in the world. Dimon's position as CEO gives him an inside perspective of what's happening in the economy that is unmatched by anyone else on the planet.

This is why I got my attention when, in a recent interview, Dimon discussed the "crisis" that is forming in the US real estate market. Here's what he had to say:

"I want to ask you about commercial real estate. We've got nearly a trillion dollars of commercial multifamily real estate debt that will mature this year. About half of that, about $929 billion worth, is owned by banks, mostly regional banks. The rest is either securitized or due to non-bank lenders. We've seen higher levels of defaults in certain pockets of the market and a slump in property prices recently. Do you think that stress in commercial real estate will ultimately be the source of the next credit event?"

"You know, first of all, put commercial introspectively with consumer; the consumer markets are far bigger. So what happened in '07 or '08? This isn't that kind of thing, and a lot of these owners can handle what you call stress. So, in the banking system, I'm just going to focus this off for a second because there's warehouses, there's data centers, there's hospitals, and some of that stuff is actually well done. But if you take just offices, first of all, they're worth less because interest rates—when interest rates go up 300 basis points—whatever you own with the cash flow is worth 30% less. So, people—that's not a crisis, that's kind of a known thing."

"And then there's the—you know, if you have a recession, yes, it'll get worse. We don't have a recession; I think most people will be able to muddle through this, you know, refinance, put more equity in. And, of course, when you talk about defaults being higher, part of that's just a normalization process; they were so low for so long. So all of credit, you're watching this, things go up, but they're not at a crisis level, they're just kind of going to normal. So yes, if rates go up and we have a recession, there will be real estate problems, and some banks will have a much bigger real estate problem than others."

"So you think, you know, as you kind of assess the landscape and regional banks, there'll be more of a 'whack-a-mole' than a kind of domino effect as long as the economy stays like this? Will it be more of a whack-a-mole?"

"There's no—there should be no domino effect. The problems you've seen were kind of idiosyncratic problems with Silicon Valley, First Republic, New York Community Bank, and a lot of these, you know, it's also very local. I mean, you talk about real estate; I think you say blanket it. If I call it an office, I have great leases in it, it's fully leased out, 20 leases, that's completely different than the spec, go there. So you really got to dig deeper, and you know we try to do that; we look at credit about where it is. It'll be pockets."

"For generations, real estate has been considered an incredibly safe investment in the United States. It was almost as if investors couldn't lose money with real estate, even if they bought in some, let's just say, less desirable neighborhoods. The reason those houses over there—I'm buying them, those crappy ones, for an investment. What have I been saying? I don't know, real estate, buy real estate. The reason why real estate has been such a great investment over the better part of the last 50 years has to do in large part with interest rates."

"This chart here is the Fed funds effective rate. Think of this as a proxy for interest rates in the economy. As this chart shows, interest rates peaked in the '80s, and since then, rates have been on a consistent steady decline. You can literally add an arrow to this chart that follows the path interest rates took over a 30-year period. Decades of declining interest rates acted like jet fuel for real estate, pushing values to the stratosphere."

"You see, commercial real estate is valued using what is known as a capitalization rate, or cap rate for short. A cap rate is just a fancy name for the rate of return an investor anticipates for a property based on the income that property is expected to generate. The CPR formula is super simple; just take the income the property is expected to generate and divide it by the value of the property. So, let's say we have a property that is going to generate $80,000 in income this year. Let's also say that property is worth $1 million. By dividing the annual income by the property's value, we get the cap rate. So in this case, it's 8%. The higher the income relative to the property's value, the higher the cap rate. The opposite is also true: the lower the income relative to the property value, the lower the cap rate."

"By doing some simple algebra, this formula here can also be switched around. We can determine a property value by taking the income and dividing it by the cap rate. As you're about to see, changes to the cap rate can massively impact the value of the property. Remember, cap rate is just a measure of an investor's return on purchasing a property at a given price. The cap rate investors are willing to accept on a real estate investment is dependent on many things; however, one of the largest determining factors is interest rates."

"To demonstrate what I mean, let me introduce you to John. John has been working hard and diligently saving for years. He finally has a pretty good amount of money saved up, and he wants to invest it. For the sake of this example, let's say John only has two options: he can either keep those savings in his bank account earning interest, or he can purchase a property. What John should do comes down in large part to the return he can generate from each of the two different options."

"Let's say the bank is offering him a 10% interest rate on his savings. At the same time, the investment property is expected to also generate a 10% return based on the current price John would have to pay to buy it. Given that both of these options are offering John the exact same return, he would logically choose the savings account. Owning real estate is much more risky than just simply keeping your money in a bank account. With property, things break and need to get repaired. Your tenants can stop paying rent, or your property could, over time, become less desirable and stop making as much money."

"Because of this higher risk, investors need a higher return to be willing to invest in real estate. Let's say, for the sake of this example, that extra return requirement is 5 percentage points above whatever can be earned in a savings account. That means, with the savings account generating a 10% return, an investment property would have to be returning 15% a year before John would even consider it. Watch what happens as the interest rate the savings account offers declines."

"If the interest rate on the savings account falls to 7%, John now needs a 12% return to invest in real estate. Bring the savings account rate to 5%, and John now needs just a 10% return on the property. Take the savings account rate down to 0%, and now real estate looks attractive, generating a measly 5% return. While this is, of course, a hypothetical example, it helps demonstrate exactly what has happened since the 1980s."

"As interest rates fell, real estate investors were willing to settle for lower cap rates, aka returns, when it came to buying property. These lower and lower cap rates sent real estate values skyrocketing. You're about to see exactly how. Let's go back to our property from earlier that generated $80,000 a year in income. At a 15% cap rate, that property is worth $533,000. Taking the cap rate down to 12% pushes the value up to $667,000. If we get really wild and take the cap rate all the way down to 5%, the property's value shoots up to a whopping $1.6 million."

"Notice how the amount of income the property generates didn't increase by a single dollar. The only thing that changed was that, over time, investors were willing to accept lower and lower returns. These lower and lower cap rates pushed real estate values to ever-increasing prices. However, things are now reversing. Interest rates have jumped rapidly to their highest levels in 20 years, the impacts of which have the potential to be devastating for the real estate market, leaving property owners underwater on their loans and banks stuck holding the bag."

"Imagine an investor that bought an apartment building during the peak of the real estate bubble at a 3% cap rate. During this time, interest rates were incredibly low, and this 3% cap rate potentially seemed completely reasonable at the time. Let's say for the sake of this example, that apartment building is generating $100,000 in annual income. Using our formula from earlier, we know this building is worth $3.33 million at a 3% cap rate. This value is calculated by dividing the annual income by the cap rate."

"Like most real estate owners, our investor here purchased the property using a loan. In our case, the loan amount is 70% of the property value, so roughly $2.3 million. Now let's see what happens as interest rates increase and cap rates move higher. Instead of a 3% cap rate, let's say the cap rate for this building increases to 6%. So instead of $3.33 million, the building is now worth $1.66 million. The cap rate doubling caused the property value to get cut in half."

"But wait, it gets even worse. This problem is magnified due to the fact that the property was purchased using a large amount of debt. Our investor here has a $2.3 million loan on a property that is now only worth $1.66 million. This is what it looks like to be what is referred to as underwater on a loan: the asset used as collateral in the loan falls so much in value that the borrower owes more money than what the asset is currently worth. In this example here, the real estate investor would likely be wiped out, and the bank that made the loan would be forced to eat the loss."

"According to Jamie Dimon, whether Draconian situations like this become widespread in the real estate market depends in large part on what happens with the economy and interest rates. Listen to Dimon explain what he's seeing."

"You always got to look at markets; they change their mind pretty quickly. But right now, confidence is up, more M&A chatter, equities market open a little bit, spreads are getting close to historical lows, which means, you know, there's a lot of money chasing high-yield deals. So things are open, markets are high, people feel it—so far, so good. That sounds to run somewhat counter to your more bearish views. I know you said in fourth quarter earnings last month that inflation may be stickier, rates may be higher than the markets expect. Is that still your base case, and what's kind of fueling that more cautious tone right now?"

"Yeah, so the way I look—you know, remember in 1972, you felt great too before any crash. You felt great, and then, so things changed. So, you've got to look ahead, and I do think there are things out there which are kind of concerning. Got an eye on. And so, why are we doing so well? A lot of it is fiscal spending, and fiscal spending has a multiplier too. So I just think it may not come down that quick, and people may be surprised."

"So when people talk about, you know, the market is kind of pricing a soft landing, that may very well happen. But, you know, the odds at 70% or 80%, I would give them half of that. That's all. Seven or eight rate cuts? No. 70—70% or 80% chance we'll have a soft landing? I give it half that. We may very well have one, but I think there's also a higher chance in the market of things of rates being a little bit higher."

"The other thing I think it's always a mistake to do is look at just a year. All these factors we talk about—QT, fiscal spending, deficits, the geopolitics—those things may play out over multiple years, but they will play out, and they will have an effect. We just don't know what they are. So I'm just, you know, in my mind, I'm kind of cautious about everything."

"You're hedging?"

"Yeah. In addition to impacting real estate, higher interest rates also have a dampening effect on the economy more broadly. To demonstrate what I mean, picture your favorite local restaurant in your hometown. For the sake of this example, the owner of your favorite restaurant loves the experience his business provides customers and wants to open up another location in a different town to be able to serve more guests. Unfortunately, the restaurant industry is a notoriously tough business. Despite working nonstop, chances are the owner of the restaurant doesn't have a ton of money sitting around to open a second location. Opening a restaurant is not cheap."

"According to a survey of restaurant owners, it costs anywhere between $175,000 to $2 million to open up a single location. Because of the large amount of money required, the restaurant owner is going to have to rely on a loan from a local bank to be able to open the second location. For the sake of this example, let's say $1 million is needed to open that second location. The interest rate on that loan is going to have a huge impact on whether our owner here can afford to expand."

"Let's say the owner is able to get that $1 million on a 10-year loan at a 3% interest rate. The monthly payment on that loan is $965. If we take that interest rate up to 7%, the monthly payment jumps to $1,610. If the interest rate goes up even further to 12%, that monthly payment shoots all the way up to $1,347. As we talked about earlier, restaurants operate on razor-thin margins. Having to pay thousands of dollars in additional interest on the loan quickly makes it so the numbers behind opening a second location start to not make sense."

"Whether or not this second location gets opened will have ripple effects throughout the economy. If it does get opened, think of all the positive benefits to the economy: new jobs will be created for the servers and kitchen staff that will get hired, local contractors and tradesmen will get more work as they renovate the property to get it ready for the grand opening, and it doesn't end there. All of the companies that sell the furniture, linens, uniforms, and food needed at this location will get more business. The list goes on and on, but you get the point. If this restaurant is opened, it is going to be a positive for the economy."

"This, of course, is just a simple example, but it does help demonstrate why low interest rates are stimulative for the economy. Currently, many people believe interest rates are definitely coming down in the not-so-distant future. Jamie Dimon is more skeptical and thinks lower interest rates are far from guaranteed. Only time will tell with how things play out, but one thing is for certain: if interest rates remain elevated or even increase, it's easy to see how that could lead to some serious pain in the real estate market."

"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."