Real Estate Investing Versus Real Estate Speculation
19 November 2007
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Real estate is a tremendous tool for wealth building and preservation. The main benefit of real estate ownership is the potential for cash flow, or passive income. Many people have also made a killing in the market just by flipping properties over the past 10 years. However, those days are long gone. So where to we go from here? What type of properties should we buy with the current market conditions? When it comes down to it, there are two ways of doing things with real estate. You can be an investor, or you can be a speculator. Here are the pros and cons on both sides.
Invest in Real Estate
I define a real estate investment as a physical asset you purchase that produces calculable returns. In general, if you buy a property and it produces cashflow, you’re in the investor category. The beauty of positive cashflow is the fact that you see your return on investment month after month. You get a physical check and it goes into your bank account. Theres no guess work involved. The only variable is potential appreciation and future rent prices, which should be treated as the icing on the cake. Appreciation should never be the focal point of your investment. The last 10 years was nothing like anything that has ever happened in US history, and now we’re seeing prices come back to reality. If you’re going to invest in real estate, you need to make sure you’re producing cash flow.
Real Estate Speculation
Real estate speculation often gets confused with investing. Two people can purchase two properties right next to one another, yet one can be investing while the other is speculating. This depends on how the financing is structured. My definition of real estate speculation is anything that does not produce cashflow. In that situation, you’re hoping for appreciation to cover your ass monthly losses and that’s called speculating. Most people who had put small down payments on numerous properties with negative cashflow in 2003-2004 are feeling the hurt right now. I know quite a bit of people who have negative cashflow of $500-$2000 a month and its not a good feeling.
Yes, there are potential deals out there that are so good that you can buy the property with little down, flip it in two years and possibly make money. Examples are bank owned foreclosures or short sales. However, many people who do this often forget to calculate expenses correctly. These expenses include carrying costs (negative cashflow), selling costs (5-6%), closing costs on the buy and sell, and capital gains taxes. You may find a great bargain, but when its all said and done it may not have been worth all the effort.
Rehabbing a fixer upper also falls into the category of speculation. You won’t be earning any money during the remodel, sale and closing period, but you will have expenses. Therefore you are still depending on the property selling at the price you want it to sell it. However, rehabbing is not all bad since it is short term and an experienced rehabber would know how much it costs to put the property in a position where it can sell fast and at a healthy profit. My thoughts on most rehab projects is that you can make a lot of money but you can also run into costly and time consuming hurdles. I would only approach a rehab project if the estimated ROI is through the roof and if the property is in a great area.
The Bottom Line
The bottom line is that if you speculate, you’re taking on more risk in hopes for more reward. You can take $50K and put down payments on five foreclosed properties in some markets. If you make $10k on each property after all expenses in two years, you’re return is 50% annually, which is astounding. However, the keyword in the last sentence is “if”. On the other hand, if the market doesn’t do what you want it to do, you can be paying those monthly expenses, also known as feeding the alligator, for five years straight with no end in sight. You’d be lucky to sell it later on and break even. If you don’t have enough of a down payment to ensure positive cashflow, either look in another market or keep investing in other assets until you can invest in real estate. Don’t become a speculator because all those gurus who sell books told you how easy it is to buy with little or no money down.
If you play it safe and invest in one property at a time that produces positive cashflow, you know for sure you’re earning a return on your investment regardless of whether or not the market does what you want it to do. What I try to do is find great deals, such as foreclosed properties or motivated sellers who will sell 10-15% below market value. I’ll then invest enough so that it produces positive cashflow that rivals stock market benchmark returns, and I’ll plan to hold it for at least 10 years. That way I know I’m earning a good return on investment. When I do sell, the appreciation and the fact that I bought it below market value produces those profits that are the icing on the cake.
The last thing I want to say about this is that if you’re producing positive cash flow, the market finds you. You don’t have to time the market since you’re earning cashflow anyway. You can wait for a great time to sell whereas a speculator may find themselves in trouble and are therefore be forced to sell even when the time is wrong, which is exactly whats going on nationwide at the moment. Positive cashflow investors are staying put and enjoying their cashflow.
Thumbnail image by Christopher Chan
The problem I’ve had with this is that there are few properties that are cashflow positive. I’ve put down 20% in a property in 2003 and 2004 (to live in as my primary residence). It’s value is pretty much the same as it was then. I got a fantastic opportunity that required relocation. At the time I would have had to take a loss with selling, so I turned it into an investment property. It’s about $500/mo. cashflow negative (though after you count free equity and tax savings on depreciation it’s probably close to break even).
It seems like it’s simply impossible to invest in real estate nowadays. I think calculated speculation, as long as you can easily cover any shortfall, isn’t all that bad though. In 30 years, it will be paid off and will still be earning rent. Or perhaps I’ll sell it for a sudden windfall.
Hi Lazy man (I’ll never get used to saying that without it sounding negative lol),
I agree with you that it is tough to find cashflow positive properties. But its only tough in certain high priced markets, where the cost of entry is sky high. I live in San Francisco but I will likely never invest another dime in the state of CA. There are plenty of properties that have positive cashflow producing great returns and they are still easy to get into in a lot of US markets. Tomorrow I have a post showing how I calculate returns on rental property and the numbers shown is for a real property on the market in Houston.
Although sometimes you may even find something in your area. deals are everywhere but they are usually made off of the market. A friend of mine was able to buy a 4 unit building in the bay area, 0% down and it was cashflow POSITIVE. Sure it doesn’t come around often but there are always opportunities. He basically has an infinite ROI.
I respectfully disagree that calculated speculation isn’t that bad. I think its dangerous because you are paying into it every month with nothing but hope that it will appreciate. You risk losing all of your equity if an emergency comes up. In order for you to make money on it, everyone else’s house around you will have to appreciate as well. I’d rather have calculated returns AND potential for appreciation.
I agree with you that in 30 years it will be paid off and you will have rental income on it forever. What I’m saying however, is that the ROI for that 30 years suck if you’re cashflow negative. You might as well invest the down payment and monthly negative in another vehicle like stocks, prosper, business whatever for that same 30 years and after that you can buy 2 of those same properties all cash and earn rent from both. For example 150k down payment, 6000 a year negative, at 8% ROI for 30 years is approx 2.2 Million. So when compared to that, a negative ROI property doesn’t seem like a good deal at all. Now if its a cashflow positive property however, you’ll likely see 15-30% internal rate of return if you look, and that surely beats an index fund or anything else that I know of besides a business(or selling crack).
Anyway sorry for going way over what I intended to write. Check out my post tomorrow. Thanks for commenting and happy Turkey day.
Danny- Great comparison of investing vs speculation, plus wonderful response in your comment to Lazy Man. I couldn’t agree with you more. The RE industry has made a killing over the last few years promoting speculative “gambling”. Good people have been led to believe that you can’t go wrong in RE and therefore, often don’t look closely at the numbers until it’s too late.
Interesting. One of our neighbors purchased 7 houses in our small (2 blocks by 3 blocks) centrally located 1970s development. He lived in one, put his two daughters & their spouses in two others, and rented the other four. This was before the run-up of the Bubble.
At one point, he remarked that he didn’t get enough rent on any of them to cover the mortgage payments. However, he figured that after ten or fifteen years, when he planned to retire, he would be able to sell them for enough combined equity to go home to Romania and live like a king. As it develops, in the Old Country about a hundred grand puts you into the near-royalty category.
Come the Bubble, this guy was smart enough to sell at the peak. He pocketed a nice profit, rented the place he was living in, and moved himself and his wife into a nicer property in the fancier neighborhood adjoining ours. This still left him with enough cash to buy an even more upscale house and hold it speculatively. He made money on that even after the Bubble burst.
I guess you could say he combined investment with speculation (and added a healthy dollop of raw luck). In his case, the line between investing and speculation seems a little blurry.
My son and I recently copurchased a house for him to fix up and live in for five to ten years, after which we will rent or sell it. Actually, he already IS renting, having taken in a tenant to help cover mortgage and renovation costs. Personally, I feel less than confident that we’ll make out like the neighborhood rental baron…but hope that planning a long-term hold will mitigate losses to some degree.
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