Ever heard of the 17th century Dutch tulip bubble? Tulips were introduced to the Netherlands from Turkey at the end of the 16th century. The Dutch people loved them and within a few decades their love turned into an obsession. Putting all reason aside, people started “investing” in tulips like there was no tomorrow. Or were they speculating? And what is the difference between speculating vs investing?
At the height of the market, tulip bulbs were sold for as much as six years of an average worker’s annual income. Tulips traded for the same price as 12 acres of land, and in some cases for the price of a small estate. Yes, we are talking about a tulip.
Of course it all collapsed and the price of tulips eventually returned to the price of a regular onion. Thousands of “investors” lost their homes, their fortunes and their self-esteem.
So what does this have to do with real estate investing?
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Do you invest or speculate?
The tulip ‘investors’ failed because they confused their speculation with real investing.
Some of the world’s most successful investors use a theory called “value investing.” Value investing was invented by Benjamin Graham and David Dodd in their 1934 book boek Security analysis. While they are focused on stocks, their theories apply to all types of assets.
The authors distinguish between investors and speculators. Graham and Dodd said: “An investment operation is one that, after thorough analysis, promises security of principal and adequate returns. Operations that do not meet these requirements are speculative.”
To shorten it:
- If you’ve done a thorough evaluation and you’re reasonably confident that your principal is safe – and you have a chance of making a profit – then you invest.
- If you are “investing” in an asset with uncertain principal protection – and you have a chance of making a profit – then you are speculating.
Is it okay to speculate? Of course, as long as it’s clear to you that you do. Many people have made millions of dollars investing in small startup companies such as Apple, Microsoft and Airbnb. But the vast majority of speculators lose their money, their time, their energy and sometimes their relationships and health.
Unlike many other asset classes, real estate offers the opportunity to invest rather than speculate.
- Chosen wisely, real estate offers a deposit of principal.
- In many cases, real estate has a good chance of making a lasting profit.
- In carefully chosen locations, real estate is likely to increase in value.
With real estate investing, investors have been able to:
- Earn up to $100,000 each of overgrown waterfront lots before the crash.
- Average over $20,000 per flip on over 60 homes.
- Develop a subdivision and make 55% profit.
- Offer stable ROIs to many investors by sponsoring projects.
It is true that real estate offers the opportunity to invest if you do it the right way. But there are also uncertainties in real estate that will make you speculate – with the potential for profit.
How is real estate speculation possible? Here are four ways.
1. Market selection
Poor market selection can be a form of speculation. I remember getting a “screaming deal” on a house in Ridgeway, Virginia in 2001. Not only was it nationwide, but the recently departed textile industry created an unemployment rate of about 22%.
Needless to say, I didn’t commit murder on that deal. But still, I survived, got almost all my director back and lived to see another day. Many tech speculators only dream of coming out this good.
2. Asset Selection
You may pay too much or too much for home upgrades. You can buy an object with structural problems. You can fall in love with the style of a home and overestimate its resale value. These are all forms of speculation.
It may look like this:
- Spending too much on upgrades for a house that turns you around. The rehabilitation budget was $80,000, but after finishing the basement and more, you spent over $100,000. The damage: Making $16,000 in profit instead of the $40,000 you’d hoped for.
- Buying a house with hidden structural problems. By forgoing a pre-purchase inspection and closing quickly to get a better deal, you may not notice the needed basement wall repairs that will cost you $10,000 or $12,000. The Damage: Still over $20,000 in profit.
- Fall in love with a charming Cape Cod home in need of significant upgrades. By not knowing the area well, you may not realize that the resale price will be much lower than you had hoped. The Damage: Losing about $3,000.
Do you see the trend here? Even when speculating in real estate, the asset’s underlying value sometimes limits losses. These three speculative mistakes still make up a total profit of over $30,000.
Speculation in stocks, precious metals or startups rarely goes so well.
You can speculate about timing. All real estate is local. So it’s not necessarily right to say, “The real estate market is in a bubble.” Instead, you could say, “The San Francisco market is in a bubble.” It is possible to speculate by buying too high on the wrong market.
My friend Mike took his first foray into real estate rental after college in the late 1980s. He and his three friends moved into a Bay Area home that had doubled (or tripled?) in price in recent years. Five bedrooms for $500,000 sounds cheap for San Fran today; however, that was pricey three decades ago. But they felt safe because they knew how quickly prices were rising.
Then the bottom fell away.
My friend and his partners lost their money and their house.
I bought my first home in metro Detroit around the same time for $50,000 and sold it a few years later for $55,000. I was happy with my 10%, especially after Mike’s story.
4. Speculative Development
Real estate developers are among the richest people in the world. Or maybe some of the richest people in the world are real estate developers. Some of the brackiest are too. (Is that a word? It should be.)
While many developers are very successful, there are probably many more who have gone out of business and have now moved into higher paying jobs, like delivering pizza. And many developers who were hugely successful in one market cycle lost all that and more in the next.
Do you want to become a developer? Go for it. I will encourage you. But realize that there is a lot at stake and that you have left the safety zone of many other real estate investments. You are definitely in the speculation zone. (It’s like the Twilight Zone, but it’s even scarier.)
You may protest – you intended to make 55% profit on your subdivision!
Yes that’s right. But you didn’t really calculate the significant risk you took to end up in bankruptcy court.
Sometimes you only see your path clearly in the rearview mirror.
The tulip “investors” were convinced that they had made it. Their tulip bulbs bore the weight of their homes, finances, and relationships — until they became comparable to an onion.
Which tulips do you hunt?
Speculation is not only bad, as shown in real estate, but it is never a guarantee. At least with investing you know that your profit will not be the price of an onion.