Mar272013

What’s the difference between speculation and investment?

I write often about investment and compare that to what I consider speculation. I originally wrote this post on the subject more than five years ago, but since I have picked up many new readers along the way, I felt it was time to revisit this important topic.

Speculation or Investment?

Real estate is viewed by many people as a good investment. Realtors often use this idea as part of their sales pitch. This view is fallacious and it is one of the beliefs responsible for creating an asset price bubble. To understand why houses are not a good investment, one needs to understand the difference between investment and speculation.

An investment is an asset purchased to obtain a predictable and consistent cashflow. This would include things such as bonds and rental properties or even cash in a savings account. The value of the asset is based on the cashflow, and this value can be determined in a number of ways. For a “point in time” analysis simple division will yield the rate of return (return = income / investment.) Risk is evaluated by comparing the rate of return of the investment to the safe return one can obtain in a savings account or government bonds. For more complex financial structures the value can be determined by a process known as discounted cashflow analysis. The sales price at the time of disposition is often not a major factor in the investment decision, particularly if the eventual disposition is many years in the future. In fact, true investments need never be sold to be profitable. As Warren Buffet noted “I buy on the assumption that they could close the market the next day and not reopen it for five years.” In contrast to investment, speculation is the purchase of an asset to sell at a later date at a higher price (Actually, you can also speculate by selling first and buying later in a process known as “selling short.”) Speculative assets are not valued based on cashflow but instead are valued based on the perceived probability of selling later for a profit. Houses can be purchased as an investment at the right price, but most often when people purchase a property they are engaging in speculation based on the belief they will be able to sell the house for a profit at a later date.

A study by Robert Shiller has shown that historically houses have appreciated at 0.7% over the general rate of inflation since 1890.

Over the long term house values are tied to incomes because people buy houses with mortgages for which they must qualify based on their income. Inflation keeps pace with wage growth because people will bid up the prices of all goods and services with their available income. Therefore, long term house prices, wages and inflation all move in tandem. There are short term fluctuations in this relationship due to variations in financing terms and irrational exuberance, but any such deviations from the mean will be corrected over time by market forces. As an investment, houses serve as a hedge against the corrosive effect of inflation, but over the long term appreciation in excess of the general rate of inflation is not possible. In this regard, houses are little better than savings accounts as an asset class, and they are inferior to stocks or bonds in the long term.

Leverage and Debt

As a speculative investment, residential real estate has the potential to make or lose vast sums of money due to the impact of financial leverage (debt.) Houses are typically leveraged at 80% of their value. During the Great Housing Bubble, this leverage was often provided at 100% by various lenders. Leverage is a powerful ally when prices increase, but leverage works just as strongly against the speculator when prices decrease. For example, if a house is leveraged 80% and it increases in value 5% in one year, the return to the investor is actually 25% due to the 5 times multiplier created by leverage. With the effect of leverage, returns generated by speculation on housing can far exceed any competing investment strategy. However, the inverse is also true. If a house is leveraged 80% and it decreases in value 5% in one year, the loss to the investor is 25% of their down payment not just the 5% the house declined in value. Leverage magnifies both the return and the risk of any speculative venture.

One of the worst mistakes lenders made during the Great Housing Bubble was to allow 100% financing and negative amortization loans. This was a boon for speculators because it allowed them to participate in the market without any of their own capital, and it allowed them to hold the speculative assets with a minimal debt service expense. Plus, there was the implicit idea that they would simply default if the deal did not go in their favor (which of course many did.) Combine these facts with the near elimination of loan underwriting standards allowing anyone to participate, and the conditions are perfect for rampant speculation and a wild increase in prices.

Why Speculators Fail

Despite the huge price spike in the final two years of the bubble caused by wild speculation, most speculators will lose a great deal of money. The causes are rooted in basic human emotions that work against making the proper decisions to profit in a speculative market. The moment a speculative asset is purchased and the speculator has taken a position in the market, emotions are immediately in play. If the potential resale price in the market is rising, the natural reaction is to want more. Greed takes over and the asset is strongly coveted by the speculator. If possible, the speculator will go out and purchase more of the asset in question. This was common in the bubble when people would take the equity from one property and purchase even more residential real estate. The problem with this natural emotional reaction is that it prevents the speculator from selling the asset and taking profits when they are available. People who make a living participating in speculative markets have learned to override this natural instinct and sell when their emotions are telling them to buy more. The average residential real estate speculator does not have this discipline or awareness. They will hold the asset through the good times.

When prices begin to fall in a speculative market, most speculators immediately lapse into denial. They were so emotionally rewarded by purchasing and holding the asset, they see no reason to believe the first signs of a declining market are anything other than a temporary aberration. As prices continue to fall, the emotions change: fear begins to creep in, and the battle between denial and fear goes on well past the breakeven point where the speculator could have closed the position without losing any money. As prices fall further, the fear begins to take an emotional toll and the speculator starts to feel pain. The further prices drop, the more pain is inflicted on the speculator. What is the natural reaction to pain? Push it away. As a speculative investment becomes painful, the natural reaction is to want to get rid of it. This prompts the speculator to sell the asset – only after they have lost money. A speculator’s emotions always work against them. When the asset is rising in price they want more of it, and when it is falling in price they want less. This is a natural reaction, and it is the cause of all losses in speculative markets. This is why most speculators fail.

Two Kinds of Real Estate Investors

There are two types of true real estate investors: Rent Savers and Cashflow Investors. These two groups will enter a real estate market without regard to future appreciation because either the cash savings or the positive cashflow warrant the purchase price of the asset. These people are largely immune to the emotional pratfalls of speculators because the value to the investment to them is not dependent upon a profit to be garnered when the asset is sold. They will hold the asset through any price declines because they are not feeling any pain when prices drop. Since these investors will purchase houses even if prices are declining, they are the ones who move in to create a bottom and end the cycle of declining prices.

In a declining market, a market where by definition there is more must-sell inventory than there are buyers to absorb it, it takes an influx of new buyers to restore balance. Since it is foolish to buy with the expectation of appreciation in a declining market, the buyers who were frantically bidding up the values of properties in the rally are notably absent from the market. With the exception of the occasional knife-catcher, these potential buyers simply do not buy. This absence of buyers perpetuates the decline once it starts. Add to that the inevitable foreclosures in a price decline, and the result is unending downward spiral. It takes Rent Savers and Cashflow Investors to enter the market to provide support, break the cycle and create a bottom.

Rent Savers are buyers who enter the market when it is less expensive to own than to rent. It doesn’t matter to these people what houses trade for in the market in the future. They are not buying with fantasies of appreciation. They just know they are saving money over renting, and that is good enough for them. Cashflow Investors have a different agenda; they want to turn a monthly profit from ownership. For them, the cost of ownership must be less than prevailing rent for them to make a return on their equity investment. Cashflow Investors form a durable bottom. If prices drop low enough for this group to get into the market, the influx of investment capital can be extraordinary (as evidenced by the huge influx of private equity buyers operating REO-to-rental business models).

Buyer Support Levels

When do Rent Savers and Cashflow Investors move in to a market and create a bottom? In the post Should you rent, or should you own? there is a detailed analysis of the true cost of ownership. When comparative rents come into alignment with the total cost of ownership, Rent Savers enter the market and begin purchasing real estate. It makes sense for them to do so because ownership becomes a savings over renting (hence the term Rent Saver.) The “return” on the investment is the hedge against inflation the Rent Saver obtains by locking in the cost of housing with a 30-year, fixed-rate, fully-amortized mortgage. As rents in the area continue to increase, these costs are not borne by the Rent Saver. Rent Savers will enter the market when it’s cheaper to own than to rent. There will be knife catchers who enter at higher prices, but there will not be enough of them to stabilize the market. It takes a decline in prices to where it is less expensive to own than to rent before enough new buyers enter the market to create a bottom. However, there are some properties that Rent Savers do not want because they really don’t want to live in them. This includes transitory housing like apartments or small apartment-like condominiums. Prices on these properties will generally drop below rental parity for owner occupants until they reach price levels where Cashflow Investors will purchase them as rental properties. Since these investors do not want to merely break even, the price must be low enough for the rental rate to exceed the cost of ownership by enough to provide a return on the investor’s capital.

Conclusion

When it comes time to consider purchasing a house, it is important to know if the motivation is one of an investor or one of a speculator. Investment in real estate requires an accurate assessment of the revenue (or savings) and the costs associated with the property. If the cashflow from the property warrants the purchase of the investment — without regard to future asset value — then it is a true investment, and the risks of ownership are much reduced. If the property’s asset resale value were to decline, the investment value would still be there, and the investor would feel no pain and no pressure to sell. In contrast, speculation is a loser’s game, and if the motivation is to capture a windfall from future appreciation, there is a good chance it may not work out as planned because the emotions of a speculator will cause a sale at the worst possible time. A few can put their emotions aside and properly evaluate the market and trade the asset, but most who profit from speculation simply sold at the right time due to life’s circumstances. In short, they were lucky. The people who bought late in the rally held on to the asset while they drifted further and further underwater: they were not so lucky…