On Wall Street, leverage is the name of the game. Just like investors and property owners can leverage equity on physical properties, large investment firms, such as real estate investment trusts (REITs), brokerages, or mutual funds, can leverage credit or debt by using margin calls. Margin calls are common practice in the financial world and are used frequently to leverage debt to help achieve a higher return on investment (ROI). Gain a better understanding of what a margin call is, how REITs can use margin trading, and how margin calls can impact REIT investors.
What is a margin call?
To understand a margin call, one must understand what a margin account is. A margin account is when an investor is purchasing stock or securities with borrowed money from the brokerage firm. Essentially the firm is using debt to borrow more debt to buy more securities. The investor puts in cash to meet the initial margin requirement, which can be anywhere from 10% to 75% of the total investment amount, depending on the investor's credit score and the overall volatility of the equity. The remaining funds come from the broker in the form of a margin loan. This is called margin trading.
A margin call is when the account value drops below the minimum margin established by the broker prior to purchasing the stock or security. When that margin is hit, then the investor must deposit additional funds into the investment account to fund the difference; otherwise, the broker will sell off a portion of the stock to cover it. The brokerage will decide which securities and how many securities are sold if it does not get the cash in the required period of time outlined in the margin agreement.
How do REITs use margin calls?
Mortgage REITs (mREITs) which invest in debt securities, such as mortgage-backed securities (MBS) and commercial mortgage-backed securities (CMBS), commonly use margin debt to leverage the debt on their balance sheet. This provides liquidity to the firm in order to purchase additional securities for a smaller up-front cost. However, in the event of a financial crisis, similar to what we saw at the start of the pandemic in April of 2020, if uncertainty in the market creates volatility, the margin can be called. If too many margin calls happen at once, the system eventually collapses, as too many debt obligations cannot be met.