I am in favor of real estate investing, but I despise real estate speculation. While the two are similar in that they involve real property, the mindsets of the perpetrators are different.
A real estate investor is concerned primarily with the intrinsic, and the improvable value of a property. Intrinsically, the value of a property is the sum of the discounted returns from that property plus any residual value left. If we look at a fourplex, we have a stream of rents that we apply a cap value formula against. We take the gross rents, subtract property taxes, insurance, vacancy factor, and maintenance to arrive at an income stream. Assuming rents were $40,000 per annum, insurance $1,200 per annum, property taxes $3,800 per annum, maintenance was $2,000 per annum, and the vacancy factor was 5% or $2,000, would result in an income stream of $31,000 per annum. We do not look at financing costs yet in our analysis. We assume a residual land value of $50,000.
With the property earning a stream of $31,000 per annum, we divide by the cap rate, add the residual to arrive at the value of the property to an investor.
If the cap rate was 10%, the value of the fourplex would be; rent streams = $310,000 + residual = $50,000, giving the property a value of $360,000.
If the Cap rate was 8%, the value of the fourplex would be; rent streams = $387,500 + residual = $50,000, giving the property a value of $437,500.
If the Cap rate was 5%, the value of the fourplex would be; rent streams = $620,000 + residual = $50,000, giving the property a value of $670,000.
If one notes from these examples, the valuation of real estate investments is very similar to a bond. The cap rate is basically a expected yield formula, and this results in the value of the property is basically an inverse function of the investors implicit rate.
An investor when he is looking to purchase a property does his inspection, performs his analysis, and if the asking price is below his calculation of the properties intrinsic value, the investor purchases the property. If the asking price is above the intrinsic value the investor walks away.
Now comes the Real Estate Speculator................
The real estate speculator is an irrational beast. The closest analogy in nature would be a wildebeest. An animal that is incapable of seeing past the other wildebeests arseholse. No rhyme, no reason, just a mindless following of a leaderless heard.
The smart speculator realizes that he is a fool. The dumb speculator thinks they are intelligent.
A speculator generally looks at a property after the serious real estate investor has decided to pass on it. The speculator uses no tools to assess an intrinsic value. Instead they follow what is called the GREATER FOOL THEORY.
The speculator is certain property is going only up, and even though the purchase of a property makes no economic sense, the speculator is certain that there is someone out there (A GREATER FOOL THAN THE SPECULATOR) that will pay a substantially higher price, than they are prepared to pay.
I have seen both the smart speculator and the dumb speculators in action. The casino that I have watched them play in is condominium presales.
Both types of speculators have as much need for the Condo's as they need a hole in the head.
The smart speculator knows that the condo investment is not viable by any investment criteria. The dumb speculator has no idea, nor desire to study any investment criteria.
The smart speculator's greatest fear is having to close on the condo presale. They know that closing on the condo is similar to slashing ones wrists. Success means bleeding to death. So they will assign their agreement to purchase the condo to a buyer as soon as possible.
The dumb speculator can't comprehend what is involved with owning the condo. The only thing they comprehend is that the condo is going only up in value. They have no fear of closing, and they will often avoid assigning their presale contract for a tidy profit because of the certainty that holding on to the sales agreement will generate more money. Eventually, the dumb speculator closes on the presale condo (lets assume for $500,000), and much to their surprise the carrying costs are greatly in excess of a rental stream. They list the condo for sale at $550,000, but they can't find fool that is more foolish than they are. The serious investor looks at the condo, applies the valuation formula, and figures the condo is worth 75% of the speculators purchase price, and offers $375,000. If the speculator is smart, he will counter offer and see if its possible to get their loss below $100,000.
But lest we forget we are dealing with a fool here.........
The speculator gets indignant at the offer, makes a reference to the investors Mother, and holds out for a better offer....... All the while carrying a $500,000 debt. All the while making interest payments that cannot be covered by the rent. By paying the property taxes and the strata fees, out of ones vocational pay. Living off of credit cards during the months that the condo is vacant. Watching the wear and tear slowly bleed the resale value of the condo away........
Vladimir Lenin decreed that anyone caught speculating in necessities is shot on the spot they are speculating. While this is quick clean and effective, it seems that showing the children the morality play of the Slow Death of Many Cuts of the Dumb Speculator, serves a better purpose since it is more likely to deter future irrational speculative behavior.....
Till again....
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