There are two times in a man’s life when he should not speculate: when he can’t afford it, and when he can.
Mark Twain (1835-1910) U.S. humorist, writer and lecturer.
As a theory of investing, this works pretty well…
Investing is the process of shifting cash (capital) from those with money, but without good ideas, to those with good ideas but no money.
In other words, investors realise that others can earn better returns with their capital than they can. There are many business owners and entrepreneurs who have great ideas to build and grow businesses, but require capital to do so.
This all works well enough. But there are some that get confused. They are those who want to be investors but do so by becoming entrepreneurs. Who are these people? …Property speculators.
I put it to you that there is a big difference between property speculators and property developers. A property developer finds and purchases properties where they see untapped potential. Their skill is seeing potential and pouring their resources, knowledge and skill into helping a property reach that potential. Once done, they can retain the property, which now has higher earning potential, or they can sell at a higher price than they bought at. The people that make the real money in property do this. It’s not riskless, but the value added by the developer makes a big difference.
Henry Ford, American industrialist, defined speculation as “covering the making of money out of the manipulation of prices, instead of supplying goods and services”.
Thus, a speculator is someone who really requires property prices to increase for their investment to succeed. A speculator, unlike a developer, doesn’t ’improve the property’. They don’t see untapped potential that they plan to exploit. They don’t often add value in terms of their skills or ability They simply take what they’ve purchased, hold on to it, perhaps rent it out at market value in the meantime, and hope…
What do they hope for? They hope that somebody, someday, will eventually come along and pay them more, for virtually the same but older property, than they paid someone else for it.
Here’s the main problem with speculation…sometimes it works! And when it works, it can work fantastically well. If property prices boom, then speculation can make you look like a hero and the envy of all your friends. It’s easy money…
And it works as long as someone is willing to pay more for the property than you paid (some call this ’The Bigger Idiot Theory’, but that seems a bit harsh). But if you don’t improve the property, the hope that someone will pay more than you did for it is really out of your control.
Let’s review the two main types of property speculation – the dangerous kind and the really dangerous kind.
First, the dangerous kind of speculation
This is most akin to investing. If done well, you seek a property with excellent cash flow, typically above 5%. What makes it speculation is that you don’t really have a plan to improve the property to make it more valuable. You sort of just hope that, somewhere down the line, you can sell it on at a gain. The rents are your saving grace. But, in most cases, with borrowing, the property won’t be cash flow positive for several years.
The very fact that you borrow money to purchase the property means you are not the investor (the person supplying the extra capital), you are now the entrepreneur (the person accepting investors’ money in order to earn returns). You are the source of the return. You are the CEO that turns opportunity into reality; that creates new value! You are not merely supplying capital for a return, you are creating value. Thus, borrowing money without a plan to create any additional value is (as it should be) a pretty dangerous game.
We drafted a financial model to help those thinking about such opportunities consider the risks and what’s required to make money.
Let’s say you buy a $400,000 property and put down 20%, which is $80,000. You borrow the rest at 7% (recent 5-year average is 7.8%) over a 25 year period. You use a property manager at prevailing market prices for such services, you pay your normal rates and insurance and $2,000 a year for maintenance (adjusted by inflation). You rent for $22,000 a year (increasing by 2.5% a year) but have a couple of weeks’ normal vacancy. Lastly, you pay normal entry and exit costs, including lawyers’ fees, etc.
All assumptions are listed below:
You own the property for 10 years and then sell. What’s your return? Well, it’s highly dependent on what property prices do. If property stays flat, then your return is approximately negative 7.54% per annum with 9 years of negative cash flow…hence the speculation. Property prices must increase in order for you to make money.
If property appreciates at inflation (3%) then you earn 3.85% per annum, and if your property appreciates by 5% a year then your return is 8.69%. But if property depreciates at 1% then your return is a negative 15.15% per annum.
That’s right, a negative 1% per annum fall in your property’s price translates into a negative 15.15% per annum return for you. It’s also worth noting that we haven’t accounted for big capital improvements such as a new roof, painting, fencing, plumbing, etc. Those costs, though tax deductible, would further erode returns if not recouped through increased selling value and rents.
Nevertheless, if your rental income is strong and you can increase it yearly, as we’ve assumed above, then this speculation may turn into a reasonable investment. You’ll have to put some time into it though, and be prepared for negative cash flows.
One last consideration is the fees. On a $400,000 property we estimate fees of approximately $6,720 the first year, not including transaction or financing costs.
If you compare that $6,740 in fees with the $400,000 price tag of the property, the fee ratio is about 1.68%. However, you should really look at that fee relative to your $80,000 equity investment. In that case your fee ratio is 8.40%! That’s pretty steep, and worth considering before you make your property investment.
Now, the really dangerous kind of speculation
Here, the speculator invests in a property with no rental income at all, doesn’t improve the property and simply hopes (prays?) for someone to come along and pay them more for the property at some stage in the future. If this sounds like Pegasus, that’s exactly what I’m thinking about.
Now, imagine the same property under the same circumstances I described before, but now there’s no rental income. Clearly, there are also no maintenance, building insurance or property management fees.
Now you sell in 4 years (those speculating on open land aren’t likely to hold for 10 years with no cash flow). What was your return? If the property experiences no growth you lose about $117,000, with an annual rate of return equal to negative 40.29%. If the property appreciates at the rate of inflation, you have a negative 22.83% annual return on total losses of about $82,000. Growth of 5% gives you negative 14.48% annual returns with losses of $58,000. And if your property experiences negative 1% growth per annum, your annual rate of return is negative 48.90%. You end up losing $128,000, more than wiping out that initial $80,000 investment. It really takes property appreciation of 13% – 14% per annum before this speculation starts to pay off well… But what an incredible risk to take.
Let’s summarise below.
Conclusion
Those that invest in property can be developers or speculators. Developers improve property, making it more valuable. There is skill in this profession, which developers deploy to make a good living. It is certainly helped by, but does not specifically depend on, improving property prices generally. Speculators, on the other hand, are highly dependent on improving property prices to make their bet work out.
Amongst speculators, the least dangerous are those that find properties that pay excellent rents which they can increase annually. These speculators should be prepared to inject new money for years after their initial investment and not be in a position where they need to get their capital out of the property quickly, because this is very difficult to do with real property. These speculators should also be prepared to maintain their properties so they remain attractive as a rental and they can then increase rental prices. If done properly and with cash flow in mind, this model really moves from speculation to investing.
Then there is the most dangerous speculation – property not earning any rents. Here, you are almost entirely dependent on increases in land value to make money. If you borrow to finance bare land, cash flow becomes a nightmare. This type of speculation only works out when there is significant growth. It sounds attractive because there are no tenants or maintenance to worry about, but that’s a false comfort. That’s like saying business is attractive if there are no customers.
The simple fact is that many property speculators actually want to be investors. If you’re not a property developer focused on improving property and making it more valuable, consider other options that will help you achieve the same goals with less time and risk involved.
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