but it all has consequences and and I think we're we're about well we are starting to see the consequences of billionaire investor Warren Buffett is warning about a major storm that is about to strike the U. S real estate market this 1. 4 trillion dollar 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 Buffet 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 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 U.
S 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 berkshire's never been very important very active in commercial real estate it it works better for taxable investors than it does for corporations tax the way Berkshire is so I I don't anticipate huge effects on Bircher 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 awfully it will often involve a different set of owners yeah in the buildings the buildings don't go away but the owners do over the last 15 years the U. S real estate market has been fueled by massive amounts of cheap debt take a look at this chart of the U. S 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 zero percent these low interest rates incentivize the use of massive amounts of debt and push 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 one million dollars 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 ticket a loan for the remaining six hundred and fifty thousand dollars 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 five percent this means that each year our buyer is responsible for paying five percent of the total loan amount in interest payments to the bank think of this as the equivalent of a mortgage payment for a homeowner add a five percent interest rate the annual debt payment to the bank is thirty two thousand five hundred dollars 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 sixty thousand dollars 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 so in our case the sixty thousand dollars and dividing that by the annual debt payment in this example the thirty two thousand five hundred dollars which leaves us with a dser of 1.
85 times as a general rule of thumb Banks like to see a dscr of greater than 1. 2 times at an interest rate of 5 and with net operating income of sixty thousand dollars 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 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 three to five 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 one million dollar office building let's take the interest rate of the loan from five percent to seven percent this higher interest rate causes the annual debt payment to jump from 32 500 all the way to forty five thousand five hundred 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 nine percent the debt payment on this building skyrockets to fifty eight thousand five hundred the sixty thousand dollars 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 sixty thousand down to forty thousand as 10 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 and and real estate and and uh one time I asked Charlie on there was some real estate guy we were talking to him and you know how do they decide how much they can a building like this is worth and it's the answer is it's whatever they can borrow without signing their name and if you look at that real estate generally you'll understand what the phenomena is happening if you do if you remind yourself that that's the attitude of most people that have uh become big in the in in the real estate business and and uh uh and it does mean that the lenders are the ones that that the property and of course they don't want the property usually so then the real estate operator comes on negotiating with them and and the banks tend to you know extend and pretend and there's all kinds of activities that arrive out of out of commercial real estate development which occurs on a big big scale but it all has consequences and and I think we're we're about well we are starting to see the consequences of people who could borrow it two and a half percent 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 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 four hundred thousand dollar 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 dollars the real estate investment firm contributes 10 million dollars and borrows the other 40 million needed to purchase the price property from a bank in the form of non-recourse debt a few years passed 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 dollars 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 dollar 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 U.
S city currently the office building is only 60 percent full down from 90 percent 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 effect 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 U.
