Real Estate Investment Versus Real Estate Speculation - What Is The Difference?

By Author: Lawrence Roberts
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Owner-occupied residential 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 great investment in most circumstances, 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. Note that houses purchased as rental properties can be a good investment if the monthly rental income exceeds the cost of ownership. There have been very few houses prices this low since the real estate bubble began inflating.

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. Just because a speculator is holding an asset for the long term does not mean the asset is an investment. If the profit is obtained primarily through changing asset values, it is speculation.

Since 1890 houses have appreciated at 0.7% over the general rate of inflation. Over the long term house values are tied to incomes because most 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 goods and services with their available income. Therefore, over the long term house prices, wages and inflation all move in concert.

There are short-term fluctuations in this relationship due to variations in financing terms, migration patterns, employment, local limits on construction 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 much 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.

The Great Housing Bubble witnessed speculation in real estate markets on a grand scale. Most speculators believed they were investors, and when prices went up, they believed they were the next Donald Trump or Warren Buffet. In reality they were the next Charles Ponzi participating in a massive, unsustainable debt pyramid. The Great Housing Bubble was a classic financial mania, and most of its participants got burned.
About Author:
Lawrence Roberts is the author of The Great Housing Bubble: Why Did House Prices Fall?
Learn more and get FREE eBooks at: http://www.thegreathousingbubble.com/
Read the author's daily dispatches at The Irvine Housing Blog: http://www.irvinehousingblog.com/ Visit Real Estate Investment versus Real Estate Speculation - What is the Difference?.