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If rates rise and a recession begins, real estate will have problems. And some banks will have much bigger problems with real estate than others . You'll 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 assets of $3.7 trillion, JP Morgan is one of the largest and most powerful financial institutions in the world.
The position of CEO gives Dimon a unique understanding of economic processes , so I paid attention to how in one of the recent interviews he discussed the so- called crisis brewing in the US real estate market. That's what he said. Um, I want to ask you about commercial real estate. We have nearly a trillion dollars in commercial multifamily debt coming due this year.
About half of that amount is $929 billion. Um , half of this belongs to banks, mostly regional ones. The rest is either securitized assets or debts to non-bank creditors. We are seeing higher default rates in certain market sectors and a recent decline in property prices. Do you think that tensions in the commercial real estate sector will cause the next credit crunch?
You know, first of all, let's compare the commercial sector with the consumer sector. Consumer markets are much larger. So , what happened in 2007-2008 is a completely different story. And many owners of such assets can handle what you call tension. So, for the banking system, I'll focus on offices, because there are also warehouses , data centers, hospitals, and some of them are doing quite well.
But if we take only offices, then, first of all, they cost less because of interest rates. When interest rates rise by 300 basis points, any asset with cash flow loses 30% of its value. And that's why, people, this is not a crisis. This is a completely expected thing. And then, you know, if there 's a recession, yeah, things will get worse .
If there is no recession , I think most people will be able to somehow get out of it: refinance, invest more equity. And of course, when you talk about rising defaults, part of it is just a normalization process. They have been that low for a long time. So in lending, you see that the indicators are increasing, but they are not yet at crisis levels.
They just go back to normal. So, yes, if rates go up and a recession starts, there will be problems with real estate, and some banks will have much bigger problems with it than others. So you think, assessing the situation with regional banks, that it will be more of a game of "hammer and mole" than a domino effect.
As long as the economy remains the same , it will be more of a game of " hammer and moles." There should be no domino effect . The problems that we saw were more specific to Silicon Valley, First Republic, New York Community Bank, and a lot of them, you know, are very local in nature. I mean, when you talk about real estate, I think you say "everywhere." If I call it an office, and it has great leases, it's fully leased for 20 years—that's not what speculative development is at all.
So we need to dig deeper, and we try to do that when we assess credit risks based on where they arise. These will be isolated cases. For generations, real estate has been considered an incredibly safe investment in the United States. It seemed that investors could hardly lose money on real estate, even if they bought it in, let's say, less attractive areas.
These houses. Do you see those houses over there? I buy them. Are those terrible? Why? As an investment. What have I been saying all along? I don't know. Real estate. Buy real estate. The reason real estate has been such a great investment for most of the last 50 years has a lot to do with interest rates.
This graph here shows the effective federal funds rate . Consider this an indicator of interest rates in the economy. As this graph shows, interest rates peaked in the 1980s and have been steadily and steadily declining ever since. You could literally add an arrow to this graph , showing the path that rates have taken over the past 30 years.
Decades of low interest rates have acted as jet fuel for real estate, pushing prices into the stratosphere. You see, commercial real estate is valued using what is called a capitalization rate, or cap rate for short. The capitalization rate is just a fancy name for the rate of return an investor expects from an asset, based on the income that the asset is expected to generate .
The formula for the capitalization rate is extremely simple. Simply take the expected income from the property and divide it by the cost of that property. So, let's say we have a property that will bring in $80,000 in income this year. Let's also assume that this object costs $1 million . By dividing the annual income by the value of the object, we will obtain the capitalization rate.
So, in this case—8%. The higher the income relative to the value of the property, the higher the capitalization rate . The reverse is also true. The lower the income relative to the value of the property, the lower the capitalization rate. Using simple algebra, this formula can be modified. We can determine the value of an object by dividing the income by the capitalization rate.
As you will now see, changes in the capitalization rate can significantly affect the value of real estate. Remember, the capitalization rate is just an indicator of the investor's income from purchasing an object at a certain price. The capitalization rate that investors are willing to accept depends on many factors.
However, one of the most important determining factors is interest rates. To explain what I mean , let me introduce you to John. John worked hard and saved money diligently for many years. He has finally saved up a pretty decent amount and wants to invest it. For the sake of this example, let's assume that John has only two options.
He can keep these savings in a bank account at interest or purchase real estate . What John should do depends largely on the income he can earn from each of these two options. Suppose the bank offers him 10% per annum on his savings. At the same time, the investment property is also expected to yield a 10% return, based on the current price he has to pay.
Since both options offer John the same income, it makes sense that he would choose the savings account. Owning real estate is much riskier than simply keeping money in a bank account . With real estate, things break and need repair. Tenants may stop paying rent, or the property may become less attractive over time and bring in less money.
Because of this higher risk, investors need a higher return to be willing to invest in real estate. Let's assume for this example that this additional yield requirement is 5 percentage points above what you can get on a savings account. This means that with a 10% savings account return, the investment property would have to yield 15% per annum before John would even consider it.
See what happens when the interest rate on a savings account goes down. If the interest rate on a savings account drops to 7%, John now needs a return of 12% to invest in real estate. Lower the savings account rate to 5%, and John now only needs 10 % of the property income. Lower your savings account rate to 0% , and real estate becomes attractive, even if it yields a meager 5% income.
While this is, of course, a hypothetical example, it helps to understand exactly what has been happening since the 1980s. As interest rates fell, real estate investors were willing to accept lower capitalization rates, meaning lower income from the purchase of properties. These increasingly lower capitalization rates have caused real estate values to skyrocket.
You will now see exactly how this works. Let's go back to our property, which previously brought in $80,000 in income per year . At a capitalization rate of 15%, such an object costs $533,000. Reducing the capitalization rate to 12% increases the value to $667,000. If we go further and lower the capitalization rate to 5%, the value of the property would skyrocket to a whopping $1.6 million.
Please note that the amount of revenue generated by the facility has not increased by a single dollar. The only thing that has changed is that over time, investors have become willing to accept ever smaller returns. These increasingly lower capitalization rates pushed real estate prices to a steady increase .
However, now the situation is changing to the opposite. Interest rates have skyrocketed to their highest levels in 20 years. The consequences of this could be devastating for the real estate market, leaving homeowners with "underwater" loans and banks with losses. Imagine an investor who purchased an apartment building at the peak of the real estate market at a capitalization rate of 3%.
At that time, interest rates were extremely low , and such a capitalization rate of 3% seemed quite acceptable. Let's assume for this example that this apartment building generates $100,000 in annual income. Using our previous formula, we know that at a capitalization rate of 3%, the building is worth $3.33 million.
This value is calculated by dividing the annual income by the capitalization rate . Like most real estate owners, our investor purchased this property on credit. In our case, the loan amount is 70% of the property value , which is approximately $2.3 million. Now let's see what happens when interest rates rise and capitalization rates rise.
Instead of a capitalization rate of 3%, let the rate for this building increase to 6%. So instead of $3.33 million, the building is now worth $1.66 million. The doubling of capitalization caused real estate values to fall by half. But wait, it gets even worse. This problem is compounded by the fact that the property was purchased using a significant amount of debt.
Our investor has a $2.3 million loan on a property that is currently worth only $1.66 million. This is what a situation called being " underwater" on a loan looks like. The asset used as collateral for a loan loses so much value that the borrower owes more than the asset itself is worth. In this example, the real estate investor will likely go bankrupt, and the bank that provided the loan will be forced to cover the losses.
According to Jamie Dimon, whether such draconian situations become common in the real estate market depends largely on what happens to the economy and interest rates. Listen as Dimon explains what he observes. You should always remember that markets change their minds quite quickly. But now confidence is growing.
There is more talk of mergers and acquisitions. Stock markets are opening up a bit. Spreads are approaching historic lows, which means a lot of money is chasing profitable trades . So the situation is somewhat open. Markets are booming. People feel it. So far so good. This sounds somewhat contrary to your more pessimistic views.
I know you said during the fourth quarter reporting last month that inflation could be more resilient and rates higher than the market expects. Is this still your base scenario? And what is fueling this more cautious tone now? Yes. You know, remember 1972, then everyone felt great before any collapse, and then everything changed.
So we have to look ahead, and I do see things that are concerning, and we keep them in view. And why are we growing so well? In many ways, these are fiscal expenditures, and they have their own multiplier. So I think inflation may not come down that quickly, and people may be surprised by that. So when they say the market is expecting a "soft landing," it could very well happen, but the odds are 70 or 80%...I'd give them half of that .
That's all. Seven or eight rate cuts? No, no, 70 or 80% chance that there will be a "soft landing." I'm only giving half of that. We may well see it, but I think the likelihood of higher interest rates than the market expects is also greater. Another thing that I think is always a mistake is to look at just one year.
All these factors that we are talking about: quantitative easing, budget spending, deficits, geopolitics—all of these may unfold for years, but they will yield results and have their effect. We just don't know what it will be like. So, you know, I'm generally pretty cautious about everything. You are hedging.
In addition to affecting real estate, higher interest rates are also holding back the economy as a whole. To show what I mean, imagine your favorite restaurant in your hometown. Let's say the owner of your favorite restaurant values the experience his establishment provides to diners and wants to open another one in another city to serve more guests.
Unfortunately, the restaurant industry is an extremely difficult business. Despite continuous work, the owner most likely doesn't have a lot of free money to open a second establishment. Opening a restaurant isn't cheap. According to a survey of restaurant owners , opening a single establishment costs between $ 175,000 and $2 million .
Due to the need for a large sum of money, the owner will have to rely on a loan from a local bank to open a second establishment. For example, let's say that $1 million is needed to open that second establishment . The interest rate on this loan will have a huge impact on whether our owner can afford the expansion.
Let's say the owner was able to get that $1 million loan for 10 years. At an interest rate of 3%, the monthly payment on this loan is $9,656 . If we increase this rate to 7%, the monthly payment will increase to $11,610 . If the interest rate increases even more, to 12%, the monthly payment will jump all the way to $14,347.
As we said earlier, restaurants operate on a minimal margin. The need to pay thousands of dollars in additional interest on the loan quickly makes the business model of opening a second facility economically unfeasible. Whether this second facility opens will have ripple effects throughout the economy.
If it does open, think of all the positive effects on the economy. There will be new jobs for waiters and kitchen staff who will be hired. Local contractors and craftsmen will get more work renovating the space and preparing it for the grand opening . And it doesn't end there. All companies supplying furniture, linens, uniforms, and products for this facility will receive more orders.
This list could go on and on, but you get the point. If this restaurant opens, it will be a positive for the economy. This is, of course, just a simple example, but it demonstrates well why low interest rates stimulate the economy. Today, many believe that rates will definitely fall in the near future.
Jamie Dimon is more skeptical and believes that a rate cut is not at all guaranteed. Only time will tell how everything will turn out, but one thing is for sure. If interest rates remain high or even rise, it is easy to predict serious problems in the real estate market. These are the things. Be sure to subscribe to the channel, because my goal is to make you better investors by studying the experience of the world's most prominent investors. We'll hear from you soon.
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