Target: Adventures in Money Making – Topic: Speculative Investing

My passion is real estate.  Buying, selling, renting, or renovating.  I’ve read more books than I can recall, and spoken with more seasoned investors than I knew existed.  There are a few basic truths to real estate, a number of which are universal to all investing, the most important of which is as follows:

There is no free lunch.  In other words, if something seems too good to be true, it often is.  If you come across a reckless blogger like moneymaker.blogspot.com convinces you of a sure bet investment, odds are he hasn’t even researched it, rather he’s just picked it up from another unqualified adviser.

In his post How to Invest in Pre-Construction Flips, Moneymaker writes as follows (see my commentary in italics):

I recently tied up some SFHs in Boise, Idaho. The plan is to put down a small deposit, wait for six months until the homes are complete and then sell them for a profit. While it sounds very simple, there are some important rules to follow.

Essentially, he is buying a dirt lot, surrounded by other dirt lots, at some potentially arbitrary price determined by the builder.  There are no comparable sales to use for price analysis.  He is betting on the fact that by the time the homes are actually built, the market will have solidified a price somewhat higher than what he has agreed to pay.  The question then is this: how can this yield such good returns?  The answer is simple: the potential return of any investment will be directly correlated to the amount of risk assumed by the investor. 

The reason that the builders are selling the homes on what appear to be the low end of market value is because they don’t even know the true value, and they haven’t sold any units yet.   When these spec (speculative) communities are built (communities of homes built without having buyers pre-arranged), prices generally start low for the first buyers, and then grow as the builder gets a better idea for the demand of the homes.  This could be either really good, or really bad for an early buyer.  If you get in early and it turns out that there is little demand for the homes in that community, then prices will be lowered in order to continue with sales flow.  As a result, early buyers are immediately “upside down” in their homes.  In other words, they owe more to the bank than the house is worth.  In order to sell the home and pay off the bank, buyers have to come out of their pockets with the extra funds.  On the other hand if you buy into the community at $300K, and the final home is sold for $450, you’ve just built a quick $150K in equity.  

In the event that prices decrease, you have a few choices:  If you are living in the home as your primary residence, then there is no sense in selling.  Stick it out and wait for prices to bump up a little.  If you purchased the home for speculative/investing purposes, you can either try to sell it (in which case you’d end up owing more than you paid), or rent it out.  I’m sure however that you will find that new construction is not meant to be a rental property, and the house will operate at a significant loss (due to the gross overpayment).

1. Make sure you target an area where there is strong price increase.  After you subtract closing costs, real estate commissions and maybe holding costs, the property needs to have risen sufficiently enough to make a decent profit. example: I’ve tied up homes for $190k [included closing costs] and they’re already worth $250k even though they’re a few more months from build-out.

   Need this be said?  Whenever you’re buying a home, whether for investing or personal residence, make sure that it is in an area where prices have been historically strong and stable.  For example, a good bet is always something relatively near a body of water, or a busy, active city.  Look for the intangibles that will maintain demand even when demand in “cookie cutter” neighborhoods is lacking.
   

2. Make sure the area is experiencing actual population and job growth.

   A good comment.  Keep up to date with the population flow in your surrounding areas to determine where it is most desirable to live.  Many people make the mistake of only considering cheaper, low rent areas for investment because the prices are more affordable.  If you can achieve the same cap rate (gross annual rents divided by purchase price) in a $200k property as you can in a $100k property, and you can afford the $200k, buy it.  Eventually, your goal should be to manage as many asset dollars as possible, and which would you prefer:  1) manage 10 properties in a $1 million portfolio, or 5 properties in a $1million portfolio?  Half the tenants = half the headaches.  Also, more likely than not, prices in the nicer neighborhoods will rise or at least remain stable.
   

3. You want to ensure that the price growth isn’t just fueled by rampant investor speculation.  If so, when it comes time to sell, you won’t have any buyers.

   I couldn’t have said it better myself.  It’s very likely that you’ll have investors bidding up prices amongst themselves, creating a false demand, and then when it comes time to flip, they’re all in hot water, and the builder is on vacation in Tahiti.
   

4. Make sure you get in at the right time in the Cycle.  You don’t want to be left holding the bag at the tail end of a cycle like some Pulte home investors in Las Vegas.  After they closed, Pulte reduced the prices by as much as $100k.

   For such a “slam dunk” of an investment, it sure sounds risky, doesn’t it?  What scares me about investing in new construction, is that you buy something often times over a year before it will actually built.  In other words, you’re on pins and needles for a year hoping that the market doesn’t go south before your home is even standing.  How do you know what demand will be like in a year?  A market can flip overnight, and you’ll be left holding the bill.
   

5. Stick to bread and butter homes.  I’m buying between 1600-2000 sq ft homes in the sub 250k price range [depending on the market].  Don’t go for the super luxury homes.  That just increases your risk.  Instead go for several b&b homes.  That spreads your risk.

   Generally speaking, he’s fairly on track here.  Whether you buy new or existing construction, always position yourself such that you will have the greatest number of people competing for the home when it comes back on the market.  Although I don’t condone this investing philosophy, if you do chose to pursue it be sure not to stash all your eggs in one basket (one big house).  Why?  Although there may be some above average returns to be made, there is also an above average risk of failure.  Theoretically, if you have the guts to stay in it for a while, it should pan out in your favor .  Think of it as if you were the dealer in black jack.  There’s a good chance you’ll come out ahead if you keep sticking your money out there.  But how many times are you willing to lose before you call it quits?
   

6. Make sure you get a home inspection done.  Sometimes in a new home, the electrical won’t work or the plumbing is jacked up [because the contractor dumped plaster down the toilet].  Dont’ skimp on this $300 investment.

   A no brainer.  New or existing construction, always have an inspection.  If you are financing the purchase, it should be required by the lender.

7. Try to work out a deal with your agent.  If you use them to resell the property, ask if they’ll give you a discount on the listing fees.  Try and work out a deal with the builder.  Sometimes if you buy bulk, the builder will work out a deal with you. [difficult, but worth a shot].

   The quick answer is this: real estate agents are overpaid for the services they provide.  See my post “A Quick Shot at Real Estate Agents” for the reasoning and some negotiating hints.

8. Make sure you do your homework about taxes.  The last thing you want to do is be in the highest tax bracket or be labelled a dealer.  But thats a topic for another day.

   And more likely than not a topic that this author does not understand.  In the world of tax, there are what are called bright line cases, and then those that must be determined using facts and circumstances specific to that instance.  Whether or not you are to be considered a dealer for real estate purposes is almost always a facts and circumstances.  The confusing part is that you may be considered a dealer for some properties and an investor in others.  There are a number of different strategies that can be employed to minimize the tax dollars paid on real estate transactions, but make sure you consult a professional rather than a book or a blog, because there will be no clear answer.