Rules of Investing. A Tale of Two Investors

What would you have done in 2006?

"The market is hot!" In 2006 this is what many builders were telling anyone who had a good credit score. "I just built a home, turned around and sold it and the buyer made $100,000." Every person with a decent credit score wanted to make money just as easily! It is important to remain 'wise' amidst such 'hype'.

Investor "Wise" -vs- Investor "Hype": A Tale of Two Investors

Back in 2006 investor "Wise" called me on the phone asking for advice. "Dave, I'm thinking of building a home. I put money down with a builder and was told I can make a ton of money. Do you think it is a good idea?" In response I asked him 2 questions:

Question #1 - Median price range

Investor "wise" mentioned that the cost of the home was in the high $600s. I asked question #1: Are you buying in the median price range? "The high $600s obviously isn't in the meridian price range, but why does that matter?" The median price range is where you are safer buying a home. When demand starts to go down it hurts more in the upper price ranges, but there are always buyers in the median price range. If you are buying a home twice the median price range you are now the biggest home in the neighborhood which means what? He thought about it, "My property values can go down a lot more?" Exactly!

Question #2 - Ownership, Location, Supply

I asked question #2 "How many owner occupants live in the neighborhood?" He continued to tell me that the builder was doing the same thing with a whole bunch of investors in the neighborhood. There is a danger of having so many investment properties in the neighborhood because this inflates the supply. What happens when demand goes down and supply is high? Your home is for sale with every other investor in the neighborhood. He suddenly understood, "So I'd be stuck with a house I wouldn't be able to sell." Exactly.

So what did Investor "Wise" do? He backed out and lost the money he had already put down with the builder. In losing a couple thousand dollars he saved the hundreds of thosands of dollars the other investors in that neighborhood are losing today....not to mention his credit as well.

Investor "Hype"
Investor "Hype" called me and explained the same situation as Investor "Wise". Investor "Hype" said, "The builder has everything ready to roll and the home could be done in 6 months with money in my pocket. They have buyers ready and everything is set up!" In response I asked the same 2 questions: Are you buying in the median price range? and How many owner occupants live in the neighborhood?

Investor "Hype" seemed to understand: "Ohhhh," he said, "so you're suggesting that since the price range is twice the median price range, and because every home in this neighborhood includes investors trying to flip the new home, it is a high risk to buy the home." A year after hanging up that phone Investor "Hype" called me again. I could hear the embarassment in his voice as he once again asked for my help. "You know that home that you said was a bad idea to build....well, I did it anyway... can you help me get out of it?"

Many Investor "Hype"s existed then and still exist today. Because people make things sound so easy and so good, people fail to recognize the risk inherent in investing. Just as builder in 2006 were saying "Land and homes are a risk-free investment" and "Your money is safe here" there are many sales people preying upon the investor "hype"s out there. Be wary of hype! Remember to always assess your risk. 2006 was a huge money making year for builders and investors. 2008 was the year they lost everything they had: their businesses, their cars, their homes, and the strain caused some to even lose their relationships. When you take on risk, it is more than just your credit score that is on the line. There are always unintended and unforseen consequences.

Making money in real estate

If you want to invest in Real Estate remember to assess the risks, and invest wisely. Seasoning and adding value are the two ways to make money in Real Estate. You must own something for a space of time. This is why rentals are great ways to invest. Someone else makes your payments and over time you accumulate wealth. There are still risks here, but the number one rule in making money in real estate is that it takes time.

The second way to make money is to add value. In 2006, when people bought a home and resold it a month later for $20,000, they were not adding value. As we saw, this can not last forever. For example, a foreclosed home that had been torn apart could be fixed up and resold looking like a new home. This is a great value added sale because most people could not have afforded to fix it up themselves.

If you are looking into making money in real estate remember to ask the right questions to assess the risks and always keep in mind the 2 ways to make money: Seasoning and add value.