Fifteenth Edition - Harsh Reality Newsletter

Good morning, everyone! Today is the Fifteenth edition of the "Harsh Reality" newsletter! If you're new here, welcome to the fight. If you want to see previous editions of the newsletter they'll be available at the link below. And if you want to join us on our social media platforms click on those links as well. Our intent is to always provide you more value than we receive so thank you for being here and enjoy the show.

Weekly Dose of "Harsh Reality"

Morgan Stanley believes that the Commercial Real Estate Market is heading for something “Worse than the Great Financial Crisis.”

Harsh Reality - They’re not wrong.. Lets nerd out on the details for a minute..

The first thing to understand is that commercial mortgages are not like private mortgages. When we’re talking about commercial mortgages, we’re talking about mortgages for commercial real estate, apartments with more than 4 units, large sky-scrapers with various offices for lease, etc. They also have much different terms than private mortgages.

All commercial mortgages are adjustable rate mortgages. These are called “balloons” and they can occur at different increments. Some mortgages are adjusted every 5 years, some every 10, etc.

The amortization schedule, how long you have to pay the loan off, is also typically shorter. Most amortization schedules for commercial real estate are 20 years or less.

Also, the interest rates are higher than private mortgages and the loan amounts are significantly higher. On average you can expect to pay 1-3% more on interest depending on how large/safe the banks consider the business to be. Premium pricing for commercial property is self explanatory but it lends to the impact that interest rates can have on the underlying business paying the mortgage.

Scenario: If a company took out a commercial mortgage for $1M in 2019, they probably had a rate in the neighborhood of 5.5% - 8%. Lets average that out and land on 6.75% or a payment of $7,455/month when amortized over 20 years. If that mortgage ballooned up to 9.5%, the new payment would be $9,325/month.. Given that most businesses operate on a 10%-15% profit margin, this could easily put them out of business.

Over the next two years, 50% of all commercial mortgages will “readjust.” That means that they’ll reach their “balloon” dates. When this happens, the interest rate “balloons” to the prevailing market rate. Think about that.. 50% of all businesses mortgages will readjust in the next two years to the new higher interest rate. That higher cost will force real estate prices down and could put businesses underwater (owing more than their buildings are worth).

Now lets get scary for a moment. What happens to the banks who own these mortgages when they readjust and the underlying businesses can’t pay, and the buildings aren’t worth what is owed on them?

2008 Happens.. But this time it’s because of the Federal Reserve increasing interest rates, not because of bad lending practices from banks.

Here’s why you should care.. Those businesses that can’t pay their mortgages.. Those are the ones you work for. And those regional banks that own the mortgages that could fail.. Those are the banks where you keep your money.. And to everyone that says the FDIC will protect you.. I say maybe.. Safeguard yourselves..

Shit That Matters

The Debt Ceiling Crisis Looms - This week Janet Yellen issued a warning that a default could occur as early as 1 June 2023.

Harsh Reality - Literally no one care what this woman is saying. The markets did not bother to react to her assertion and if the date were actually correct then we’ve already missed the timeline given the writing/voting process. She needs to stop the politics and bullsh!t and focus on the actual date of default before she causes a crash of her own.

House Republicans and Joe Biden’s staff continue to negotiate. As of right now the standoff seems to be over work requirements for food stamps and medicaid.

Fitch and Morningstar Ratings Agencies Place US On Downgrade Watch - This comes on the back of yet another politically driven “crisis” over the debt ceiling.

Harsh Reality - A downgrade on U.S. credit has actual impacts on our ability to function as a nation. It increases our cost to borrow money and kills the value of bonds that have already been issued. The last time the U.S. credit was downgraded was in August of 2011 and the following monday the markets crashed and the crash has since been dubbed “Black Monday.”

The Presidential Primary Season Is Heating Up - This week, two more Republicans announced their candidacy for the 2024 Presidential race.

Harsh Reality - The more the merrier. After both Tim Scott and Ron Desantis announced, there are now five candidates on the republican side. Former President Trump continues to hold a significant lead over all of the other candidates. Do not be surprised to see one of the unsuccessful candidates named as a running mate for whomever wins the nomination.

Russo-Ukrainian War - Both sides scored symbolic wins this week in the Russo-Ukrainian War.

Harsh Reality - The advances on both sides are mostly symbolic and have little impact on the bigger picture. There is, however, one serious item to discuss.

Vladimir Putin announced this week that non-strategic nuclear weapons would be staged in Belarus. Putin issued a statement to NATO stating that he will use them if the Russian sovereignty is placed at risk. He closed that topic with a final warning, “This is not a bluff..”

Bakhmut has officially fallen to Wagner. The Russians have also announced a tactical pause to allow their troops to consolidate their gains and to prepare for the next offensive. Yevgeny Prigozhin, the leader of Wagner, did not miss his chance to talk smack to the Russian General Staff either.. He stated that Wagner would depart Bakhmut but that he would leave behind two of his mercenaries to hold the line in case the Russians retreated from their defensive positions.

Russia also attempted to kill the head of the Ukrainian military, Valerii Zaluzhnyi, with a missile strike. Several OSI providers questioned whether or not they were successful until a video of him was posted by the Ukrainian military.

On the Ukrainian side, shortly after Bakhmut fell, the Ukrainians launched an incursion into the Russian border area near Belgorod. They used a Russian Separatist Regiment to destroy a border checkpoint and an FSB (think Russian CIA) building. Residents in Belgorod were also shown panicking over the prospect of the Ukrainians assaulting the city itself. The Ukrainians have since withdrawn from the area, again, scoring a symbolic win.

Federal Reserve Will Not Rule Out More Rate Hikes - This week the Fed released a statement that they will not rule out additional rate hikes in 2023.

Harsh Reality - This shouldn’t be a surprise to anyone. We’re currently sitting at 5.25%, the rate they targeted when inflation popped up to almost 9%. Inflation is still holding strong; but even if inflation does give over the next month or two, it could surge back in the 4th quarter leading to additional hikes.

Category 5 Typhoon Mawar Rages - Luckily, Guam was only clipped by the then-category 4 typhoon. The typhoon has since increased to a category 5 and threatens the Northern Philippines and Taiwan.

Harsh Reality - Given the poor quality of construction in the south pacific islands, a category 4 or 5 typhoon can absolutely destroy the areas they hit. Guam, and it looks like the Philippines will be lucky and will be missed slightly. Taiwan may be hit but they’re in a much better position to weather such a strike.

Weekly Market Recap

Shit That Doesn't Matter

Tina Turner, “The Queen of Rock & Roll,” Dies At 83 - The legendary singer is said to have passed peacefully from natural causes.

Harsh Reality - Hats off to her for a long and successful career. She had a great impact on the music industry and will remembered for that instead of some drug riddled tragedy like most.

Tom Brady Secures Minority Stake in Las Vegas Raiders - The details have not been released but the agreement will require concurrence from 24 other 32 NFL owners.

Harsh Reality - Good for him.. I guess this, along with his $375M deal with Fox Sports, means he’s actually retiring..

NHL Stanley Cup Playoffs - The Florida Panthers have swept the Carolina Hurricans in the East and will advance to the Finals. In the West, the Vegas Golden Knights lead the Dallas Stars 3 games to 1.

Harsh Reality - I love me some hockey and I’m excited to see the Golden Knights, founded in 2017, doing so well. This would be a true Cinderella story if they win it all. Unfortunately, my team didn’t even make the playoffs..

The NBA Championship.. - The Miami Heat leads the Boston Celtics 3 Games to 2. The Denver Nuggets locked in their position in the championship after sweeping the Lakers in 4 straight games.

Harsh Reality - Lebron lost.. That’s really all I care about.

That's A Wrap!

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