Buyers Use Margin Loans to Buy Real Estate
During the internet stock bubble of 1999-2000, there was a great hullabaloo about how many people used margin loans (borrowed money from their broker) to buy stocks.
At the time, many newspaper articles quoted people saying things like, “That’s crazy! I’d never use margin (borrow money) to buy something as risky as stocks.”
Yet many of the people who would never use margin loans to buy stocks use margin loans to buy real estate.
Say what?
To clarify, for stocks, there are different margin requirements depending on what stock you are buying. Some stocks are not marginable; you cannot borrow money against them to buy more stocks. For the strongest stocks, you can borrow up to roughly 3 times your money.
For example, if you want to buy Microsoft stock, you are required to have 30% equity. So if you have $10,000, you can buy up to $33,333 worth of Microsoft. Your 30% equity is collateral for the 70% that you borrow.
That’s a leverage ratio (LR) of approximately 3-to-1.
“That’s nuts!” some people might say. “If the stock drops 30%, I’ll lose all my money!”
That’s very true.
Yet, people buy real estate every day using leverage ratios much higher than 3-to-1.
If you put a 20% down payment on a house purchase, your LR is 5-to-1.
If you put 10% down, the LR is 10-to-1.
If you put 5% down, the LR is 20-to-1.
If you put 0% down, the LR is infinity.
The scary part is very few home buyers today put 20%, or even 10%, down.
To continue, if you put 20% down and your LR is 5-to-1 and your house price drops 20%, you lose 100% of your money.
If you put 5% down and your house price drops 5%, you lose 100% of your money.
With stocks, the most you can lose is 100% of your money. With real estate “margin”, your losses aren't limited to 100% of your money. You can lose 100%, 200%, 300% of your money. This is especially true if you put very little money down.
But, real estate is different, right? Real estate prices always go up. Stocks are pieces of paper. Real estate is REAL. You can see it, touch it, live in it.
I agree with everything except that real estate is different and that prices always go up. Real estate is a commodity. Real estate prices are subject to the same supply and demand forces as any other economic product.
Is there a housing bubble? I don't know.
But I do know 2006 should be an interesting year.
posted by The Phantom Republican @ 9:35 AM
10 comments
10 Comments:
Thanks for explaining Leverage Ratios, PR!
I'd tend to agree with you in general, but with a caveat... As I see it, the difference between stocks and real estate is that you don't *have* to invest in the stock market, but you do have to live *somewhere*, whether you rent or buy.
In other words, I see real estate (specifically, in the case of a primary residence) as having a place to live and as a bonus, it's an investment that *typically* appreciates over time, in the long run. Especially since we're talking about tangible assets (land, construction, etc.) rather than the "perceived" value of a stock like google or yahoo or whatever. People may not always want to buy tech stocks, but they will always need a place to live in, so there's always at least *some* level of "demand".
I think your post was more focused on people who "speculate" on the real estate market, not just homeowners. And yeah, I agree, those people are taking a risk, same as (or worse, as you say) with the stock market. But then again, (in theory) people should only invest (gamble) with money they can afford to lose. In theory...
Also, unlike stocks, homes need cash to "cover" them - utilities, taxes, upkeep, association fees, etc. And some stocks actually pay a dividend while you hold them...
The "new homeowner misanthrope" clearly doesn't understand that a homeowner who buys overpriced houses with large amounts of other people's money IS a speculator. He is also a renter in the sense that he is renting the house from the mortgage holder and will probably walk away from the house when the bubble bursts just as he would move out of a rental when he finds a better deal elsewhere. When the bubble bursts, the mortgage holders will be left holding the bag and those who hold onto their real estate will suffer because mortgage lenders will get smarter about how much and to whom they lend their money. The result will be lower housing prices and high mortgage payments that many will find they cannot afford over a time horizon that may stretch well beyond their working years or even beyond their life expectancy.
Right now with the overpriced market I see depreciation happening not appreciation. Anyone that buys a $500,000 house will be paying more than its actually worth and be loosing money in a couple of years and have absolutely no equity because they are probably using an interest only loan. Which meens that they are not paying anything towards their home only paying the interest. They are loosing money and might as well be renting for a lot less. By the time they start paying the principal on their home it will be a $300,000 and their loan payment will be outragious and they won't be able to get out of it because they won't be able to sell their home for what they got the loan for. I personally am a renter, because there is NO way I would pay $300,000 for a fixer upper. I live in the Sacramento area, and I'm glad the bubble is finally popping. My landlord lowered my rent because rent is getting so much cheaper here than purchasing he was afraid he would loose us as renter.
The 'tangible living environment' is a true difference in the stocks vs real estate debate. You do need somewhere to live - and thus, there will ALWAYS be some baseline demand for housing by people buying for the right reasons.
That is - as a place to live. The simple response is that NOBODY can currently argue that there isn't substantial investment/speculative home buying occuring at this juncture. While the 'fixed demand' of people needing housing will likely only fluxuate lightly over time, the # of people buying on spec (including those claiming to only need shelter who took I/O's on the spec prices will rise before the axe drops in 2/3/5 years) is entirely too high relative to any measure in history. And when you realize that these people are the ones taking onrediculous Leverage Ratios as outlined here, that's the group that faces the implosion.
The problem is not the 10 year owner with substantial equity who has a 30 year that's now probably 15% of their monthly income at this point - or the millions like them - the majority of homeowners actually. It's the 10-20-30???? % of those who have taken on excessive Leverage in order to spec on real estate that can tank the entire market in any region.
The problem is enough people are taking on those types of risks/loans etc so they can not use the 'place to live' argumentin justifying their choices. This group currently controls enough $ and % volume in many markets to tank them - regardless of how diciplined the other 70% or whatever have been.
Alright - I'm back to work. Great positioning blog...
There is an interesting notion out there about "have to live somewhere". The real question is how many people are you willing to live with for the price. You don't "have" to buy or rent a house, many people can simply move back home .. or with a brother or uncle or crazy aunt Suzy. The average density per houshold is something like 2.8 people per house, if that ratio were to move just slightly to say 3.1 people per house So. California could handle all it's population growth for about 6 years without the necessity to build one new unit! If that were the case simple supple /demand pressures would not up the values
No Risk No Gain, only the people willing to take high risk will make tons of money. No doubt about it, especially in Capitalism country - USA.
I don't against your thinking, it is true to me, the LR on Real Estate is unlimited, you can lost more than you have. I came from Hong Kong and we'd been through it so many times for last few decades, but to American it's just too new to them.
Only way to win the game over Real Estate is -- Know when to stop. Want to share a princple that's always works not only in Stock Market but also in Real Estate. When everyone (all level of people, experts or amateurs) talks about how to make quick and easy money from it, it is the indication, the time to stop throwing money into that sector.
Actually, I cut all my investment on Real Estate since year 2002,
Good Luck.
Maybe one should consider owning or renting as consumption. We have to eat and cover ourselve but we generally don't consider consuming food or buying clothes as investment.
If we consider owning a place to sleep as investment, maybe then all things we do to please our body and mind are considered investments to our human capital.
Sometimes investing in yourself is the best thing than stock or real estate. Because you could be the next Bill Gate.
New Home Owner-
Yes. Real Estate typically appreciates over time.
Unless you have bought at grossly inflated prices.
In which case it can go down. Way down.
See the following blogs:
thehousingbubble2.blogspot.com
Another F@cked Borrower
etc. etc. to inform yourself
Kuperlen- you have hit the nail on the head. When you can rent the same house for far less money than it costs to own it, this is a sign that RE has detached fr/ fundamentals.
It has now entered the territory of "percieved value" which, as New Home Owner suggested, can be problematic.
Housing market will get soft but not crash at least for next 9 months. Reason: Spending 500k to purchase a property, people want to sell it at 600k level, it'll take 9 months for them to digest the fact and realize that they are losers. Then price will start to fall - FreeFall, period of "Panic selling".
That's a principle of circle that we went through long ago back in my hometown.
I am a Guy from Hong Kong.
Post a Comment
<< Home