Monday, December 19, 2005
Speculation v. Investment
What most people loosely refer to as ‘real estate flipping’ these days is no flipping at all – it is reselling for a profit. This is so because most market participants finalize the transaction before reselling their newly acquired interest in land for a mark-up. The implication is that they actually use their own money to complete - a classic real estate investment. The true fine art of ‘flipping’ houses or other real assets, on the other hand, consists in reselling an interest prior to closing. A Buyer of a subjects-free contract of purchase and sale will find another Buyer for the same interest ready, willing and able to purchase prior to the first Buyer completing the deal. The implication is that the first Buyer merely puts the deposit out of his own funds - a classic real estate speculation.
True real estate flipping, albeit not an illegal practice per se, will get you in trouble more often than not and notwithstanding anything Donald Trump will have to say on the subject. In fact, it’s gotten him in trouble as well. It is also a practice not favorably looked upon by many Boards and professional associations within organized real estate. At the centre of it all is the definition of market value with its element of proper exposure to market conditions. Imagine a purchaser that convinces a seller to accept an offer of, say, $300,000 for a single family detached house with completion in three months and a $15,000 deposit. Then, about half a way through the purchaser finds a second buyer willing to pay $350,000 for the same interest and to complete on the same day as the first contract. Come completion date the original purchaser will close on the second contract first. As it takes at least one day for documents to be couriered to the respective conveyancers and about a month (in British Columbia) for the transfer of ownership to be recorded and the new title registered at the Land Title Office, this little trick will allow the original Buyer to walk away with a neat $50,000 in his pockets, without having used his own money practically at all. As market value is, by definition, the price that a real property is reasonably expected to fetch after adequate time and exposure to market conditions, a real question arises as to whether or not the Seller in this example has received full market value for his property.
Flipping potentially encompasses an element of negligent misrepresentation, at the very least, all the more so if someone with special skills and knowledge – such as a Realtor – is involved. But even if no real estate professional is involved, the Courts have long since ruled that under certain circumstances mere silence or half truths may have the same effect as misrepresentation and are, thus, actionable at law. In some cases such misrepresentations may be even qualified as fraudulent. As no reasonable Seller will, if given a choice, sell his property for $300,000 as opposed to $350,000 lawyers have been quick at crying out loud foul play when contacted by disgruntled sellers. But beyond the legality and morality of flipping practices, there is a real economic question as to whether flipping merely contributes to the speculative inflationary ravages that ultimately reveal themselves detrimental for the entire economy, especially when they involve large ticket items such as real capital assets. This is not the case when it comes to investing or, for that matter, reselling for profit, which is looked upon as a regular part of doing business in any market. Which, then, opens up again the ages old debate going on in the economic community as it relates to the impact of speculation vis-à-vis investment.
The role of speculators in a free market economy is to absorb risk and add very little liquidity to the market place. In fact, more often than not, speculators will reduce market liquidity by inflating prices – the principal effect of speculation – and by moving their newly made riches out of a particular market for use elsewhere. This would be the case in our previous example if the first purchaser, upon completing the first transaction decided to abandon real estate and invest his capital, including the $50,000 profit, into the stock market. Moreover the effect of price increases, particularly in the short run, is to reduce the pool of buyers thus hampering demand and reducing prices even further – the classic economic bubble. Investors, on the other hand, play an entirely different role. In theoretical Economics the term ‘investment’ refers to the purchase and holding of capital goods, which are not instantaneously consumed - i.e. sold for profit – but, rather, used at a later date. Therefore a purchaser that buys a fixer-up, remodels and sells it later on for a mark-up is an investor, not a speculator. The same is true for a buyer of a property under foreclosure.
Risk management when it comes to investment is also well defined. More particularly, investment is in direct function of the underlying relation between personal income or capital appreciation, depending upon the nature of the subject property being bought and sold, and interest rates. An increase in personal income, just like an increase in capital appreciation will encourage investment to a higher degree which, in turn, will spur demand causing a proximate levitation of prices and subsequent economic expansion. Conversely, higher interest rates will discourage investment by heightening the cost of financing resulting in a lower demand and, thus, depressing prices and causing an economic constrain. Even if an investor decides to use his own funds exclusively, the measure of risk will be given by the equation between the underlying opportunity cost of investing versus the lending of those same funds for an interest profit, a process known as maximization of use of capital resources.
It all ultimately boils down to the business plan embraced by the singular market participant. If the objective is to make a ‘quick buck’ through flipping and short term speculation, the measured risk of the acquisition is considerably higher and, in ultimate analysis, no better option than the leveraged capital appreciation through investment holding.
Real Estate Chronicle
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