Munger Warns of Risks in Commercial Property Market, Urges Caution

The American commercial property market is facing headwinds, with banks being burdened by bad loans and experts warning of a potential crisis. Charlie Munger, the right-hand man of legendary investor Warren Buffett, has expressed concerns about the market, although he doesn't believe it will be as catastrophic as the 2008 collapse. Banks, according to Munger, have developed bad habits in good times and tend to lose significantly when bad times arrive. The commercial property market is experiencing turbulence as a result of factors like overbuilding, lockdowns, and shifts in remote work, all of which contribute to higher vacancy rates.

In recent times, commercial property prices have fallen sharply in countries such as Canada, where analysts predict a 50% decline, while in Britain, investment in the sector has also dwindled. These issues can be partly attributed to rising interest rates, which contribute to slowing economic activity and making loans less affordable. Overbuilding has been further exacerbated by the pandemic, with empty high-rise buildings becoming a common sight in various regions, including the UK, where vacant office space has risen by 65% in the past three years.

Such trends raise two primary concerns. First, the potential for a collapsing commercial property market to result in mass layoffs, which could lead to a recession, as experienced in 2008-09. Construction employment accounts for around 5-7% of jobs in Britain, and significant layoffs in the sector would have a substantial impact. Second, as Munger points out, the effect a collapsing commercial property market might have on the banking system.

Commercial properties are rarely financed with cash; instead, investors usually rely on debt. When properties can't be sold at the planned price, loans can't be repaid, putting pressure on the banking system. Banks are already under strain from rising interest rates and deposit flight, leading to institutional collapses. If commercial property loans go sour, the pressure on the banking system could intensify.

A collapsing commercial property bubble might also affect the residential property market. It's rare for commercial property prices to plummet while residential prices remain resilient. One reason is that both markets are driven by the same sentiment, but another is that property is substitutable. If an office building's value drops and residential property remains valuable, an investor can convert the office building into a residential one.

The British economy has been struggling, with economists closely monitoring whether a technical definition of recession has been met. There will be no recession in Britain until mass layoffs occur. Increasingly, it appears these layoffs could begin in the commercial property sector, and, given the exposure of banks that Munger highlighted, they will likely be accompanied by a financial crisis.

The US banking system has experienced turbulence lately, with closures and bailouts of Silicon Valley Bank in California and Signature Bank in New York, as well as the near-collapse of First Republic Bank in California due to a crisis of confidence. Munger suggests that banks will face challenges with their commercial real estate portfolios due to declining property values, rising office vacancies, and increased interest rates.

However, the issues banks encounter are expected to be milder than those experienced during the Great Recession of 2007-2008. Despite Berkshire Hathaway's long history of investing in banks and supporting them during financial turmoil, neither Munger nor Buffett favor the volatility stemming from commercial real estate loans. The decline in property values may not see a swift turnaround, especially in office buildings and shopping centers, as remote work continues to impact the workforce.

Banks have already started reducing their risk by approving fewer commercial real estate loans requested by developers. Munger points out that every bank in the country is now more cautious with real estate loans than they were six months ago. Despite the challenges, Berkshire Hathaway has managed to achieve compounded annual returns of nearly 20% since 1965, showcasing the resilience and strategic prowess of Buffett and Munger in navigating financial headwinds.

The commercial property market's potential collapse and its impact on the global economy are still a matter of speculation. Governments and central banks worldwide will likely take measures to prevent the situation from escalating into a full-blown crisis. The Federal Reserve, the Bank of England, and other central banks have tools at their disposal to stabilize the banking system and contain the fallout from a potential commercial property market crash.

It is crucial for investors and regulators to be vigilant in monitoring the commercial property market's developments and to learn from the lessons of the 2008 financial crisis. Banks should continue to exercise caution when extending commercial real estate loans, and regulators must enforce stricter risk management practices to mitigate the potential consequences of a market collapse.