Speculation is the purchase of a rental or commercial property with the expectation that it will grow in value in the future. It is also an effort to gain profit from short-term instability in the market value instead of trying to gain profit from the interest or dividends.
To begin with, there is a theory called “value investing.” This concept was coined in 1934 by David Dodd and Benjamin Graham in the book “Security Analysis” in relation to stocks, though this theory can be applied to all types of assets.
Graham and Dodd distinguish between speculators and investors. According to the “Security Analysis,” the investment operation is the one that promises adequate income and safety of the principal. Those operations that do not meet these requirements are defined as speculation.
To sum up, if after evaluation your principal is safe, you are investing. If the asset in which you are investing is not safe or you are not certain in the protection of the principal, and you receive the profit, then you are speculating.
Speculation and investing are similar to some extent – both usually involve the increase of the value, although speculation is relying on the advantages in the changes in the markets, rather than market behavior in a long-term perspective.
Sometimes the speculation results in extraordinary profit. People who invested in Apple, Airbnb, and Microsoft when these companies were small startups gained millions of dollars. Many speculators, on the contrary, lose their money, energy, and time.
Real estate has more opportunities to invest instead of speculating. That happens for the following reasons:
- Real estate, if chosen wisely, provides a guarantee on principal
- In most cases, it is more likely to gain profit from real estate
- The real estate grows in value in some specific locations
Let us consider the four possible ways that a person can use to speculate in real estate.
Poor Market Selection
It is the form of speculation when the realtor purchases the house or apartment for rent or resale and intentionally chooses the location with a low employment rate, small population, undeveloped infrastructure or logistics.
For example, the real estate agent can speculate on the transaction concerning the house in the rural area with a high unemployment rate, about 22%. In this case, there is a big risk of losing money.
A location is an essential option for real estate. That is why it is important to make a final choice based not only on the characteristics of the house but also on the area where it is located and the neighborhood. The size, price, and conditions of the property can be changed, although the location always remains unchangeable.
Good neighborhoods are often more expensive than bad. If you want to make a good investment, it is better to buy the property that is located in ‘next’ to the best neighborhood.
Demand and supply are two key factors that influence the appreciation of the property. In perfect locations, the housing supply is reduced to the number of houses in that are.
There are three main forms of speculation. We will describe some cases below, including some common mistakes.
- Overbuying or overspending on upgrades of the property. For instance, a broker overspends on upgrades of recently flipped house. The initial amount of finance for renovation is about $80,000 but the speculator spends $20,000 more for the repair of the basement. The potential risk of losing money is very high and ultimately it may lead to the damage – a profit of $16,000 instead of the expected $40,000.
- Buying the building with hidden structural problems. For example, a person acquires the house without a preliminary check to get a better deal, it may turn into a problem. In this particular case, the new owner of the house had to spend about $10,000-$12,000 on basement wall repair. Otherwise, there is still an opportunity to gain a good profit.
- This type of speculation occurs when the investor purchases a real estate for for personal (somewhat emotional) reasons. Sometimes it results in great losses because the property requires a large sum of money for renovation. In one case, when the investor acquired the house on the basis of his preferences, without taking into consideration the other conditions, he lost about $3,000 on this deal.
If we analyze all the three cases, we will understand that sometimes the underlying value of the asset diminishes losses and it results in a winning situation. In comparison with the speculating in startups, precious metals, stocks or oil, and gas, the speculation or real estate is more profitable.
The main feature of all real estate is its local character. One more form of speculation is timing. There is an opportunity for speculation if you buy the property at a too high cost in the wrong market.
For instance, you can buy a property that costs $500,000. This property is located in the area where the prices grow rapidly. The price can double or triple over a certain prolonged amount of time, and it is a good opportunity to receive a high return. Of course, this can be quite risky and in the end, there is a possibility of losing all your money if something goes wrong.
The speculators who rely on timing strategy have a strong influence on the whole real estate market. When several people buy and hold property in order to gain the profit from timing, it affects the supply and demand mechanisms. It creates artificial value resulting in prices increase. At the same time, the affordability of the real estate decreases for people who purchase the property for living or to have in possession a long-term investment property.
Real property development is a business process that comprises repair and leasing of properties and buying of the raw land and sale of the developed land. Investors usually purchase the real estate, estimate its value and marketing potential, create the design, search for the resources of financing and finally, sell the property. Developers experience great risk while creating and renovating the property but also, they gain very high revenue.
Real estate developers are often considered to be wealthy people. On the other hand, some of them went bankrupt. Sometimes the real estate developers may earn a high profit in one cycle and then lose everything in the other cycle.
If you want to speculate on real estate and become a real estate developer, you should not underestimate the possible risks and play for high stakes. You leave the safety zone related to other investments in rental property. It is sometimes difficult to calculate the potential risks, but it is quite easy to become bankrupt. We will consider some potential risks in more detail below.
The Risks Of Speculation
Let us compare the risks and the rewards from the speculation. The potential revenue from speculation is pretty impressive, but we cannot ignore the risks. The key factor of success is the skill level of the speculator. The skilled trader may gain higher results with lower risk.
Investing in real estate usually implies the income based on either cash flow or cash flow equivalents while holding the real property. This income comes from lease or rent. If we lease or rent the property out, we receive the constant profit, not relying on the increasing value of a piece of real estate but based on the cash flow.
Real estate speculation has a lower level of security compared to real estate investment because generally, it does not bring cashflow, or the amount of income is too low to cover all of your costs.
If the owner’s intention is to flip the property – to buy a piece of real estate, renovate it, and then sell – he will not rent the house out. The investor will try to make repairs as quickly as possible and then sell the property and move to another project.
When the person wants to hold the property to wait when the price increases, this can take a long amount of time. During this period, the property will not generate income, and sometimes the people can sit idle for decades. Quite often, the reason is the location of the property or the lack of adequate infrastructure.
For example, a piece of real property can be the acreage in the woods, not suitable for construction or living, and unusable from the marketing point of view. That is why the owners and buyers are not willing to purchase this property.
Over time, the maintenance of the property requires more additional expenses in contradiction to the investment property that brings the revenue. Notably, property speculation is often made with borrowed money.
In addition to the borrowed money, the speculator needs to take into account extra expenses, like taxes and other costs. The speculator should have some savings to manage these expenses in a comfortable way.
Let us consider the short-time speculations. In this case, if the speculator does not have enough costs, they may face some difficulties like the lack of income while holding the property, and also, they may not gain the expected amount of return if they sell this piece of real estate.
To sum up, real estate speculation requires the prediction about the growth of the price in a particular market or for a particular property or buying a real estate before the predicted leap. The growing markets are usually oversaturated with the speculators who purchase property, hoping to receive profit from the appreciation.
Real estate speculation tends to be very profitable, though it incurs great risks. If the investor happens to be right in his predictions, he can gain massive returns. To achieve this goal, the investor needs to study the trends in the local market and rely on the fact instead of guessing.
Sometimes the real estate speculation is compared to the buy-and-hold strategy of flipping but these are not the same things. According to the flipping method, the investor who acquires the property makes the improvements and upgrades in order to enhance its value.
Speculation, on the contrary, does not require changes in the value of the property, only the price alteration.