Warren Buffett sees a storm brewing in the real estate market.
“We are starting to see a 1.4 trillion dollar debt tsunami about to hit the real estate market,” said Warren Buffett.
Warren Buffett thinks the real impact begins in a few months.
We are just the beginning of the consequences of decades of cheap finance that Warren Buffett sees in this commercial real-estate bubble.
Charlie Munger, vice chairman of Berkshire Hathaway, said that Berkshire has never been active in commercial real estate, so he doesn’t anticipate huge effects on Berkshire.
“But I do think that the hollowing out of the downtowns in the United States as elsewhere in the world is going to be quite significant and unpleasant,” said Charlie Munger.
“I think the country will get through it alright, but as they say, it will often involve a different set of owners,” he said.
“We are starting to see a 1.4 trillion dollar debt tsunami about to hit the real estate market”
Warren Buffett sees a storm brewing, but the buildings will survive
“The buildings don’t go away, but the owners do,” said Warren Buffett.
“In the last 15 years, the real estate market was fuelled by massive amounts of cheap debt,” he added.
If we look at the Fed fund rates, a proxy for interest rates that stood for the best part of the last 15 years at zero percent, these low-interest rates incentivised a massive use of debt and pushed real estate values to sky-high levels.
For example, if a buyer purchased commercial real estate for one million dollars, puts down a 20% deposit of 200K USD and borrows the remaining 800K USD from the bank at an annual interest rate of 5%.
So, the annual interest rate payment to the bank in the first year is 40K USD.
Whether the property can support that debt depends on the net operating income of that property, the rent the property generates, minus the operating expenses of managing the property.
“In the last 15 years, the real estate market was fuelled by massive amounts of cheap debt”
In this example, let’s assume the property generates 50K USD income for the owner. So, property generates a 10K USD surplus income to cover the debt payment.
The Debt Service Coverage Ratio DSCR measures the ability of the property to service debt.
DSCR is calculated by dividing the rental income the property generates by the annual interest rate to the bank.
In the above example, the DSCR equals 1.25, calculated at 50 divided by 40.
As a general rule of thumb, banks like to see a DSCR greater than 1.2 times.
“The consequences of a commercial real estate loan reset are likely to be disastrous for commercial real estate owners” – Wealth Training Company
Warren Buffett sees a storm brewing in the real estate commercial market
This is because the sector is more sensitive to central bank tightening policy due to an abundance of debt financed with variable-rate mortgages, which are more interest-rate-sensitive.
Buyers of commercial properties do not have the benefit of fixed-rate interest throughout the mortgage. Commercial loans are not fixed during the duration of the loan, instead, the loan becomes due every 3-5 years and is set again at a new interest rate for that type of loan.
A trillion dollars of commercial real estate is scheduled to be reset at much higher interest rates, which is why Warren Buffett sees a storm brewing
The consequences of a commercial real estate loan reset are likely to be disastrous for commercial real estate owners.
If we take the interest on the commercial real estate loan from 5% to 7.5%, in this case, purchasing the commercial property with the same deposit is no longer financially viable as the DSCR given the same variables equals 0.83, which is less than the ideal number of 1.2 and higher.
In short, the commercial property income is now less than the cost of servicing the debt, and the landlord is likely to hand the keys to the banks and say take it.
In reality, commercial property is also more sensitive to the economic cycles of boom and bust. So, when the economy is in a downturn, the supply of commercial properties exceeds the demand, and the rent price falls.
Moreover, the macro trend, the digitalization of everything, has created a boom in work-from-home. This trend will strengthen because workers save money on transportation costs, and employers don’t need to rent large office spaces.
“I think we are starting to see the consequences of people who could borrow at 2.5%” – Warren Buffett
Warren Buffett sees a storm brewing in the real estate commercial market as landlords get triple-fisted with high interest rates, lower demand and collapsing rents
So banks end up commercial real estate landlords and will likely sell the property at a fraction to a new owner.
Ultimately, the banks will eat the losses on the loan, and this is what Buffett meant when he said the buildings don’t go away, but the owners do.
“How do people decide what a building is worth?
The answer is whatever they can borrow without signing their name,” he said.
“I think we are starting to see the consequences of people who could borrow at 2.5%,” said Warren Buffett
A non-recourse loan is why Warren Buffett sees a storm brewing
When there is a personal guarantee with the mortgage, you are on the hook to pay the mortgage.
Irrespective of what happens, you can’t hand the keys to the bank and say good luck.
If the property is sold, for less money than the mortgage, the borrower must pay the difference or file for bankruptcy.
Typically, commercial real estate is purchased with non-recourse debt.
So, if commercial real estate is purchased at a peak price when interest rates are low, then interest rates rise, and a loan interest rate reset is due and the landlord discovers that the rent can no longer service the loan, and since it is a non-recourse loan, the owner can hand the keys to the bank and walk away.
Given that the loan is a non-recourse loan the bank has no option but to eat the loss.
So a 1.4 trillion dollar loan tsunami is heading our way, making the mother of all credit liquidity squeeze and recession, maybe more like a depression, almost a certainty.