Real Estate Investing Versus Real Estate Speculation

By Danny Tsang

November 19, 2007

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.

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Written by Danny Tsang · Filed Under Investing, Pitfalls, Real Estate