I talk with people about investing in real estate most every day, and many are first time investors, meaning they own a house and maybe a vacation home, but are now looking to “invest” in real estate. The comments I often get are, “I’m thinking of purchasing another home or condominium in the neighborhood as an investment”, or “Property values appear to be increasing, and I would like to buy something so I can profit from the rise in the market”. Then they ask, “What do you think?”
First of all, it is important to understand the major difference between “Investing” and “Speculating”. Investing, to me, is buying something that provides an income stream and a tangible return on your equity. Speculating, is buying something that you hope will go up in value in order to derive a return.
Here is an example that should help illustrate my point:
Property Purchase 1 (Investment): Buying an income property that produces a cash flow above the overall cost to operate the property is, in my opinion, an investment. Think about a game of Monopoly. The cash return from a player landing on your property (say Park Place) and paying you rent was pretty much a guarantee, and probably the main reason you purchased the property in the first place.
Property Purchase 2 (Speculating): Buying another home/condo, holding it, and selling it for a profit, is more a form of speculating as opposed to investing. Think about that game of Monopoly again. Although there was a possibility that another player may want to purchase Park Place from you for more than you paid for it, there was no guarantee of that happening, and it wasn’t the main reason it was purchased.
Obviously, there are many more moving parts in the investment process than those in a game of Monopoly, but the theory is the same. You purchase a property in order to make money.
The next part of the equation is investment risk vs. speculation risk. The amount of risk you are willing to accept is another important factor in this comparison. And yes, I know, speculating is a form of investing, but since the risk is typically greater, I try and avoid using the term “investing” when talking about “speculating”.
I am sure everyone has a great story about how they or someone they know made a fortune after they purchased a home in the mid-1990’s and sold it in the mid-2000’s. But, I would imagine that everyone also has a sad story about how they or someone they know lost a fortune after they purchased a home in the mid-2000’s and the value dropped below their loan amount over the next 3-5 years. Both of those stories are products of speculation.
Alternatively, looking at an “investment” purchase (say a small apartment with a positive cash-flow) during those same two time periods (mid-90’s to mid-2000’s, and mid-2000’s to late-2000’s) would have produced a similar upside and downside in overall equity change, as compared to the home purchases described above, but with a much lower risk, everything else being equal. Why a lower risk? Because the likelihood of the holding costs being absorbed by the positive cash-flow in an “investment” purchase are much higher than in a “speculative” purchase that has little or no cash-flow. Meaning, in a market downturn, investment properties with income or cash-flow can sustain themselves versus those properties without income.
So what do I think? I think the focus of any first time investor in real estate should be on cash-flow versus equity building. Once you feel you have enough money to gamble a bit, then go ahead and look into speculating, which is a whole different story.
Authored by Kevin Falsken, President & Founder