While there is no clear cut division between speculation and investment, and all investment essentially involves speculating on the value increasing on something, speculation as opposed to investment tends to involve plays that are more speculative in nature we could say, rather than being of the category of more reliable investments.
Speculation also involves seeking to take advantages of changes in markets more, rather than relying on longer term market behavior that is expected to continue. Stocks go up over the long run for instance, or properties have held their value over the years, so one may invest in either with an expectation, or at least a hope, that this will all continue.
People may hold stocks for shorter periods, speculating on shorter term movements, or they may buy distressed stocks hoping that things will turn around, and we would consider these moves more speculative.
People can also speculate on real estate to take advantage of changing demand or markets. This may involve speculating over the short term but may also involve the long term as well, like those who may buy property in the outskirts of town at low prices, expecting that growth will eventually expand the town and increase the demand and value of these properties.
These speculations in real estate can therefore occur over a period of decades, and many a real estate speculator will boast of tales like how cheaply they bought what eventually turned out to be prime real estate once developments finally came.
On the other end of the spectrum, there are those who purchase homes which they feel are undervalued and perhaps only in need of some repair and upgrades and look to sell them a little later at a handsome profit.
These shorter term real estate speculators or traders may be seen to perform sort of an arbitrage role in the real estate market, especially with properties that sellers are looking to move quickly, like banks with foreclosures or those in dire financial straits. These sellers may not have the resources to bring their properties up to market expectations and therefore the speculators often will add value to the properties in addition to selling them more patiently to extract both their true and potential value.
The Risks of Real Estate Speculation
When we invest in real estate, we are generally relying on either cash flows or cash flow equivalents to manage the costs of holding the real estate, which generally yields some sort of profit.
This cash flow will come from either renting or leasing the property or exchanging the money that we had been spending on rent for our homes and using that to pay down and manage the property. This includes both servicing the mortgage and keeping up the property, and both are built into rent payments, and these additional costs need to also be accounted for and planned for when one owns one’s own home.
These cash flows will or at least should provide us with some profit, not in terms of speculating on the increasing value of the property, but in terms of cash flow. For instance, if we are renting or leasing the property out, we should be looking to have these payments cover all of our expenses and also provide a little profit at least.
When we own our own home, the profit may or may not be in cash. If we buy a similar property than we were renting, we should save a little, but the profit from owning is more often living in a nicer property which would cost us more if we rented.
Real estate speculation is more risky than real estate investment because there generally isn’t this cash flow, or at least a sufficient one to cover all of our costs.
If we’re looking to turn around properties, we generally aren’t going to be renting them out in the mean time, as often we’re just looking to renovate them and sell them, and the intention is to turn around these properties as quickly as we can so we can move on to another project.
When we speculate more long term, we may or may not see the property generate income for us while we wait for its value to increase enough to sell it, and often people will have these properties sit idle for years. The main reason is that they aren’t suitable yet as income, this could be some acreage in the woods for example, and these properties often aren’t fully serviced such that people would want to build anything on them, either prospective buyers or the owners.
As time passes during the speculation, this often will produce a loss as far as operating expenses go, as opposed to investments which seek a profit from operating them. Given that real estate speculation is generally done with borrowed money, the cost of borrowing here, in addition to other expenses such as taxes, will require the speculator to first and foremost have the means to manage these costs comfortably.
With shorter term speculators, if they are not prepared or do not have enough means to manage these risks, this can have them sweating the time they hold the properties as well as not getting the kind of return they had hoped from the sale of them. Many people look to get into this on more of a shoestring or relying a lot on sweat equity and they may not have thought things through carefully enough.
The time to learn one’s capacity to handle and manage these risks isn’t when one is in the heat of battle and especially when one may get into hot water, not being able to comfortably manage their debt payments and risk seeing themselves risking foreclosure. Such an event will put an end to their real estate speculating careers for many years and will also impact their ability to borrow for personal needs as well.
Differences With Real Estate Speculation
Investing in real estate can be a great way to invest due to the combination of fairly low risks as well as the ability to highly leverage your investments. A great example of this would be with one’s own home ownership, where they reap the benefits of the property going up, let’s say an average of 5% a year, and control the entire value of the property with only a small down payment and payments they would be spending on rent otherwise.
With the way real estate values increase over time, there are few investments as good as home ownership, where one’s initial investment gets leveraged up to 20 times. So, this 5% increase gets magnified significantly, where you may have put down $10,000 and see an increase of that much every year, far into the future. The payments on the mortgage aren’t even relevant here because they would be made anyway for shelter. It doesn’t get much better than this for most people.
While other real estate investment may not be quite as sweet, as we can’t leverage them as much as they will require a more substantial portion of the purchase price being put up by us, when you consider that your tenants are paying your mortgages and upkeep for you, the amount you had to put down gets leveraged in a similar way, taking advantage of increases in the value of the property over the years, which can be pretty significant relative to the initial investment.
Real estate speculation is usually a different animal though, and while we still can take advantage of some leverage, the reduced revenue streams or even the lack of one will impact how much we’re able to borrow, as we still have to show a reasonable capacity to pay back the money in a timely way. Banks don’t like to hear that the payment is on the way once we sell the place, and the risk model of banks depends on an orderly repayment schedule being maintained.
This is the reason why lines of credit are much better to use when looking to speculate on real estate in the shorter term, as one may then only worry about interest payments during the period one holds a property and may use their borrowing capacity to manage this interest, where they may simply add that on to the amount owing provided they don’t exceed the amount of their credit line.
While this can work pretty well if all goes well, we still need to plan for what we are going to do if things do not go so well, and defaulting on debts isn’t one of the acceptable options. This is why short term real estate speculation is riskier than real estate investing, and it can be a lot riskier, although the rewards can be mightier as well if one has the means to not have to rely on good luck to be successful.
Opportunity Costs of Real Estate Speculation
Whenever one invests one’s money in something, we can’t just look at the risk and return of the particular investment or speculation, we also need to compare the risks and rewards of competing investments that we could have made instead,
The potential returns of real estate speculation are pretty impressive, and if there weren’t risks involved, or if one can reduce these risks enough, and one also has a good plan that is expected to work well and especially if it has a number of times already, then real estate speculation can be a great way to make money without overly exposing oneself.
What one compares this to is going to depend on the skill level of the speculator. If for instance one was a skilled financial trader, then the person may be able to achieve even better results with even less risk, and therefore this would be a better use of one’s resources.
This very rarely is the case with real estate speculators, as the opportunities that they are foregoing with their speculation are going to be much more pedestrian ones, such as investing in mutual funds or putting their money into treasuries or a savings product.
There may be opportunities for other real estate plays though that are much more similar to real estate speculation, buying rental properties or commercial real estate for instance, investments that involve quite a bit less risk than real estate speculation.
It really does come down to both knowing what one is doing, being a skilled real estate speculator in other words, and also having the means to ride out any storm that may come their way, and things often don’t go quite as well as one may initially hope with any sort of speculation, including ones involving buying and selling property.
There are people who do well at this, but it isn’t as simple or as easy as a lot of newer speculators think, especially those who have had their expectations hyped up by the tales of others who may have done well and want you to think that it can be this easy for you.
If enough caution is used here though, speculating in real estate can be a profitable venture to be sure, but only if one is careful enough, prepared enough, and skilled enough.
Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.
