Shhh … do you hear it? It’s the margin calling …
“Margin” is a term we hear all the time but can be a little confusing … because it means different things depending on the context.
But margin comes up often in financial conversations because it’s an important concept … and worth taking a look at.
In stock trading, margin is debt secured by the stocks you’re buying. It’s like the way real estate investors use mortgages to acquire property.
Typical margin leverage with stocks is fifty percent. So you put in half and borrow the rest. If the stock goes up, you get to keep ALL the gain … just like real estate.
BUT … if the stock goes DOWN … you get a “margin call” … which means you need to bring in cash to restore the loan-to-value ratio. No fun.
We’re sure glad that doesn’t happen in real estate!
The term “margin” has another important meaning. It’s the “edge” or “fringe” … things that are farthest from the center of the target.
So when you think about your personal budget, you have things at the core … food, clothing, shelter, medical care, etc.
Out at the far edges … the margin … are highly discretionary, non-essential expenditures. These are things you can easily live without, but you enjoy when you’re flush.
These are the first things to get cut when you’re squeezed.
Households, corporations, even governments all have “core” expenses and activities … and “marginal” expenses and activities.
Again, when prosperity recedes … things at the margin fall off the target.
Our point in all this is you can learn a lot about the direction of the economy simply by watching what happens at the margin.
That’s why this headline caught our attention …
– Wall Street Journal, April 10, 2018
“ … higher mortgage rates make homeownership out of reach for many,
pressuring lenders to ease credit standards.”
“ … rising debt levels are a symptom of a market in which home prices are rising sharply in relation to incomes, driven in part by ahistoric lack of supply that is forcing prices higher.”
Hmmm … some of that doesn’t make sense to us. But before we go there, consider this headline …
– MarketWatch, April 16, 2018
“The 69 reading is still quite strong. In the go-go days of the housing bubble, between 2004 and 2005, sentiment averaged 68. Still, the fact that confidence is declining so steadily is notable. When NAHB’s index started to fall in late 2005, it was one of the signals that foreshadowed the coming housing bust.”
“ … builders are keeping the pace of construction slow and steady. And they’re worried about their costs.”
And then there’s this one …
– Associated Press via ABC News, April 17, 2018
“… driven by a big 16 percent gain in apartment buildings. Single-family home constructio
“There is a severe shortage of existing homes, which has pushed up
prices in cities around the country … That’s lifting demand for new homes.”
Again, a few things here that don’t make sense to us. And we could probably write a book just on the excerpts from these three news articles.
But let’s see if we can unpack all this briefly …
First, rising mortgage rates and prices are causing people at the margin of prospective home-ownership to remain tenants. Not great for them, but not bad for landlords.
Usually when prices rise based on DEMAND, builders ramp UP production to profit by selling into the increased demand.
So it seems to us home-builder confidence should be growing. But it’s not.
That makes us think the number of people who can afford to buy isn’t growing either … it’s shrinking.
That’s because when prices rise faster than incomes, the ability to borrow eventually peaks. Falling interest rates can delay the problem by getting more mortgage for the same payment.
But now that rates are rising, it seems people at the margin are getting pushed off the back of the affordability bus.
That may also explain why apartment building is growing, but single-family home building is declining.
It may also explain why Freddie Mac is lowering lending standards.
They can’t create jobs or increase incomes, but they can make it easier to borrow in spite of rising rates … and they are.
Freddie’s making it easier for first-time home buyers to get in and push up the market from the bottom. It’s like the air inlet in an inflatable jump house.
The concern is when lower lending standards act as the air pump trying to compensate for higher interest rates and insufficient income … how long can the debt inflation go before it tapers off … or worse?
Don’t get us wrong. We LOVE passive equity. It’s fun to buy a property and just watch the equity grow.
But the market giveth and the market taketh away … unless you’re smart enough to get your equity off the table with cheap long-term debt while both are still available.
As John F. Kennedy said, “The best time to repair the roof is when the sun is shining.”
The sun is shining on real estate right now. Enjoy it. But be sure you’re preparing your portfolio for stormy weather.
It’s probably smart to have some cash on hand … to be prepared for credit markets to tighten unexpectedly … and to lock in long-term rates where you can.
It’s also wise to pay close attention to cash-flow and avoid dependence on market factors to increase rents or values.
Make sure your deals pencil TODAY … based primarily on things you can reasonably control.
Sure, you might have to walk on some marginal deals … even though they’d be “winners” as long as the tide is high and the sun is shining.
But if the tide goes out and the storm comes, then marginal boats sink. And if they’re tethered to your best boats, they ALL sink.
Now if you just can’t resist taking a chance on a marginal deal … consider structuring it so it can’t take down the rest of your portfolio if things don’t go as planned.
Until next time … good investing!
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