Speculating Versus Investing

In a recent interview with a major newspaper the reporter asked the following: "As a speculator weren't you partially responsible for the current foreclosure crisis?"I was actually glad he asked. It gets to two things that I believe are largely misunderstood - the difference between speculating and investing and that this "crisis" was caused by Wall Street, and K Street, not Main Street.

The difference between speculating and investing is that speculating relies on future changes in market prices, while investing does not.

When I began seriously investing in real estate in 2002, it quickly became apparent that most so called residential real estate investors were actually speculators betting that prices would go up. And for a number of years they were right. When appreciation was at 20% annually you really couldn't make a mistake. Or could you? Take the guy that believed their big remodel resulted in the huge profit when they sold not realizing that the market was moving so fast they could have made more on the same property by doing nothing. And more importantly - if the market hadn't moved they would have lost 80 cents of every dollar wasted on that remodel.

This is why so many speculators got caught when the market turned down &emdash; they fundamentally hadn't made good investments. They over paid, over improved, and flat out bet on future appreciation that simply didn't materialize.

So what does it take to make the jump from speculator to investor? The bottom line is in finding properties that provide the desired return regardless of likely near term changes in price. From there we need to divide investors in to two categories:

Short-term investors look for a purchase price that is at a sufficient discount to make a desired return regardless of likely changes in market price during the holding period. The truth is that is a pretty tall order right now. But I'm starting to see prices find some support from long-term investors and discounts at auction continue to improve.

Long-term "buy and hold" investors simply want a reasonable annualized return on their investment and as such have no reason to speculate on future price changes. My long-term investor friends and customers are now starting to find bargains that meet their investment criteria as rents have remained strong, and prices in some areas have dropped significantly. One customer recently mentioned that he is buying condos for $90k that he can rent for $1,250 (he wouldn't want me to say where). Even after condo dues that is a great return.

The logic above applies to personal home purchases as well. If making the purchase relies on future price appreciation to work out that homebuyer is speculating. If on the other hand they have a comfortable payment, aren't paying a huge premium over renting, take advantage of tax breaks and pay down principal over time, they will wake up one day to realize that they've made a great investment regardless of near term price fluctuations.

As you look for properties, or help clients look, be sure to always be asking yourself - is this speculating or investing?