This means you’re on your own: you should learn to be your own market analyst. Regardless of the condition of your local real estate market, you can avoid costly investment mistakes by maintaining your objectivity, looking for the right kind of information, and making informed decisions rather than emotional ones. Here are ten strategies you should consider when taking that objective approach to investing:
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RECOGNIZE THE SIGNS OF GREED AND FEAR. Emotional reactions to markets are easy to recognize, if only because they are irrational. Greed and fear are both blind emotions in the sense that when in their grip, people just don’t think straight. In times of greed, people ignore risk and want to put more money into a venture, even when the warning signs are evident. In times of fear, people just want to get out, even if that isn’t necessary.
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RESIST THE NATURAL TENDANCY TO REACT HASTILY. To avoid the common problems that come from making decisions in response to greed and fear, never act rashly. Gather facts and think first, and be aware that most people overreact and make decisions impulsively. The old stock market advice to “buy low and sell high” clearly makes sense; the actual tendency is for people to do the exact opposite. Greed causes people to buy high, and fear causes them to sell low.
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LOOK AT THE BIG PICTURE AND IGNORE EVENTS IN THE MOMENT. Whenever markets are uncertain – and especially due to valuation changes like the cycle and bubble we have just gone through – it makes sense to resist acing or reacting in the moment. Take a step back, look at the market in historical perspective, and never make decisions quickly. Most mistakes in markets (real estate and others) are made because people have used the wrong justifications to act.
Just as different types of real estate react to completely different supply and demand forces, the same holds true within each type of real estate. In residential property groups, single-family owner-occupied housing is entirely separate from single-family rental, duplexes, condos and apartment buildings. Sudden changes in markets are likely to affect all types of
real estate in the short term, but over time the separation of supply and demand forces within markets insulate each type of property from other types.
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USE REAL ESTATE FUNDAMENTALS TO JUDGE MARKETS. It is all too easy to look only at market price and to ignore other factors. But when you compare current value to real demand, you get insights into the degree of artificial demand within your local market. Studying the key fundamentals – inventory of properties for sale, time on the market and spread between asked and sold prices – reveals what is really going on today. Price and recent historical price trends can be misleading.
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CONSIDER THE SOURCES OF INFORMATION. Any time you receive information about real estate, consider where that information is coming from. Is an organization in the business of serving speculators, investors and other types of property owners? What sources of income may affect the person’s or organization’s reasons for giving you advice? Once you understand why someone believes something about real estate values, you are in a better position to evaluate the quality of the suggestions.
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SET GOALS AND TAKE PROFITS BASED ON A PLAN. All investment programs work best when part of a comprehensive plan. How much of your capital should be invested in real estate? How does your family home fit into the plan? What are you goals for paying off mortgages? Do you want to be a landlord? All of these questions, and more, form the basis of your personal financial plan.
Too many people proceed with investments without first formulating specific investing goals. Real estate, which is illiquid compared to the stock market, should represent only a portion of your total investment assets. What is the appropriate portion for you depends on how much risk you can afford to take, your income and other assets, and your knowledge of the real estate market.
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SEEK OBJECTIVE ADVICE, AND BE AWARE THAT FINANCIAL PLANNING SHOULD BE YOUR JOB AND NOT THAT OF SOMEONE YOU PAY. An entire industry of “financial planners” provides services in return for commissions, professional fees or both. These services are promoted to help you invest your money to plan for your future. Too may people rely on financial planner’s advice without looking into alternatives themselves. This leads to an inclination to make bad decisions. Many financial planners simply refer their clients to mutual funds that include a sales commission fee, without any guarantees that the funds will perform well.
If you check with a financial planner concerning possible real estate investments, you will discover that may planners will not recommend you invest in the real estate market. First of all, it ties up a lot of capital, meaning less money is available for investments that provide
the planner with a commission. Second, most financial planners do not understand the real estate market well enough to give you practical advice.
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NEVER PUT ALL OF YOUR INVESTMENT CAPITAL IN A SINGLE MARKET. The concept of diversification is well understood in the stock market. However, in discussions of real estate management, the question rarely comes up in the sense of product diversification (real estate versus stocks, bonds, mutual funds, and savings). Diversification may be studied in terms of liquidity, with highly liquid savings accounts compared with stocks or mutual funds and real estate as different markets. But little if anything is usually brought up about whether a specific portion of investment capital should be invested in real estate in order to diversify risk.
A related concept – asset allocation – does compare dissimilar markets. Many formulas have been devised to recommend to investors that a certain percentage of capital should be placed in the stock market, real estate, or the money market. These discussions are rarely based on a logical comparison of risks; condition of the real estate market; the suggested method for placing money into the market; or an analysis of how a personal home should be included in the equation. In other words, asset allocation models may be affected by real and perceived real estate bubbles, but the recommendations put forth by brokerage firms or financial planners are often general in nature and not geared toward any one individual. And the reasoning for how money should be invested is not usually explained in terms of risk and profit potential.
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KEEP PERSONAL AND INVESTMENT ASSETS SEPARATE. There is little justification for using your personal home to try to make a profit in the market, especially if you want to speculate. The suggestion that you keep personal and investment assets separate is based on the requirements that lead most people to own their own home. Profit potential is usually secondary to the more important roots in the community (schools, friends, location) and affordability of a mortgage – in other words, the very attributes that define personal security.
The only exception I teach to his rule would be when considering private lending secured by real estate where the LTV is 65% or less and all other security provisions are accounted for (lender’s title policy, hazard insurance as additional insured, escrowed funds, etc).
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LEARN FROM YOUR MISTAKES. BETTER YET, LEARN FOM MISTAKES MADE BY OTHER PEOPLE. Smart investors learn from the expensive mistakes they make along the way. Wise investors are able to avoid making expensive mistakes by learning from the mistakes made by others. To succeed in real estate, observe how people act within the market. Make a clear distinction between home ownership, equity investments and speculation. These three are not the same, and money should not be placed at risk in the same way for any of the methods of entering the market.
It’s worth remembering that homeowners, investors and speculators – as the three primary equity owner of real estate – face their own unique risks and profit opportunities, and these are not the same for all. Even beyond these methods for owning real estate, there exists a range of many more ways to invest in real estate in the form of either equity or debt.
Additionally, in becoming a wise investor and observing the mistakes made by others, learn to read the market. Be aware that real estate consists of three distinct sub-markets:
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THE SUPPLY AND DEMAND MARKET
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THE FINANCING MARKET
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THE RENTAL MARKET
and that tracking these can help you to spot bubbles and emerging trends.
THE SUPPLY-AND-DEMAND MARKET
This is the most obvious sub-market. Isolating it from the other sub-markets makes sense, even though most people do not attempt to break out these different markets or study them specifically. The essential point in defining and analyzing this sub-market is to be able to distinguish between real demand and artificial demand. You can use those real estate fundamentals to accomplish this.
A real demand is a demand based upon a healthy and legitimate market where in a reasonable supply of housing stock is currently for sale as a six-month supply and that figure is based upon the most recent home sales per month. It creates a benchmark of sorts for understanding the health of the market. The six-month supply is not a hard and fast number because it depends upon historical sales activity.
Once you have decided on the inventory benchmark, the next step is to study the current inventory of the same property type. If an artificial demand is developing in the condo-market, but not in single-family housing, it is not accurate to lump all residential property into the same group; averaging would only distort your analysis. So assuming you are studying single-family housing to decide whether there is a real or artificial demand, compare the benchmark inventory to the actual inventory. If you base your benchmark figure on a six-month inventory and your analysis shows an actual current inventory of 24 months, it means that you define the market as an artificial demand and even heading toward a bubble. In this instance, 25% (6 months) is accounted for by real demand; the remaining 75% is a response to an artificial demand and is not a good sign when determining the health of the market.
In our example, we would ask is this a severe overage? Here again, the subjective conclusion you reach about the severity has two components:
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First is the months of excess inventory;
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Second is the trend in actual completed sales.
If prices are rising and the larger trend has been toward population increases, the market may be actually anticipating a growing real demand.
THE FINANCING MARKET
The financing market has defined the real estate market in many ways since the 1970’s, when the secondary market was formed. Before that, commercial lenders were restricted in the dollar value of their loan portfolios based upon their actual reserves – a “sensible” system because monetary policy was tied to the gold standard in a very real sense. When the US went off the gold standard, the entire concept of monetary policy changed. Since the early 1970’s the Federal Reserve has been able to print as much money as it wants. It is no coincidence that at the same time the US went off the gold standard, the secondary market in real estate was formed.
In 1975, the total dollar value of US home mortgages was $38.8 billion; by the end of 2005, outstanding mortgages were nearly 30 times higher, at over $1.1 trillion. The trend for the decade from 1995 to 2005 showed unrelenting growth, from $168 billion at the beginning of the period.
Does this translate into a problem? Absolutely, and we are only seeing the tip of this iceberg right now. However, the expansion of credit alone does not always imply that there is going to be a burst of the bubble and a corresponding down-turn in the market. There is no doubt however that liberal availability of money has enabled the price bubble to grow, in some areas without limit. Sadly, when the bubble finally burst, prices and values were the victims however reversals in lending policies are slow to change, exacerbating the problems we are currently experiencing.
The early warning signs of a collapsing market can be seen within the financing market. The signs include increased interest rates in the form of originally low and artificial adjustable rates that are adjusting at a death defying pace, which in turn causes higher rates of default and foreclosure.
THE RENTAL MARKET
The third sub-market is the rental market. To anyone outside the real estate industry, it may seem surprising that rental property has different risk factors from owner-occupied property. In fact, rental rates and trends in vacancy are very revealing. If rental properties are over-supplied in a region, higher vacancy rates indicate the rental market could experience a collapse.
Some analysts attempt to define the value of rental properties using maximum potential rent, or rents that will be earned if a property is fully rented. A study of actual rental receipts is more realistic and more accurate. This also indicates any artificial inflation in income property values.
Some income property owners will raise rents before placing properties on the market. If the current higher rents are used to determine value, the value will be inflated. So to get an accurate estimate of property value, an appraiser should use actual rental income net of vacancies over the past year, and not the current rates being charged to tenants.
In conclusion, the real estate market is often perceived an easily understood, rather simple market with clear supply-and-demand elements, manageable risks and predictable profits. This is a very false and dangerous assumption. It is far from certain however, that everyone buying real estate can make quick profits and avoid the risks of sudden and significant price declines.
There are many ways to analyze local markets to determine their health and which types of properties are being affected. You can augment your analysis of your local real estate market by further understanding the three sub-markets as we have defined them.
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