Are You an Investor or a Speculator?

“Using Other People’s Money to Get Rich…”

“Other People’s Money – The Ultimate Leverage…”

“Flip and Grow Rich”

There are hundreds of books like these available on real estate “investing”. Sounds simple, doesn’t it? Borrow lots of money and buy as many properties as you can and you will become rich! Maybe you have heard the radio or TV advertising for the real estate “guru” sessions offered around town where a fast talking salesman describes how you too can get rich quick in real estate. How do you determine if what you’re doing is investing or speculating?

Let’s start by examining the word “investor”. Everyone seems to be an investor these days. Have an E-Trade account? You’re an investor. Own a rental property? Yep, you’re an investor too. Do you have some gold coins in a safe? Well, that makes you a precious metals investor!

Or does it?

The problem is that many people today confuse speculative activity with investment activity. Let’s draw on the wisdom of two of my favorite investors to help us delineate between the two.

“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” ~Benjamin Graham and David Dodd, Security Analysis (1934)

Graham and Dodd were Warren Buffet’s mentors and profoundly impacted his investment philosophy. While they were primarily concerned with financial securities, their timeless wisdom applies equally to real estate.

Are you an investor or a speculator? Let’s breakdown Graham and Dodd’s definition of “investor”:

1.) “Upon thorough analysis”

Do you thoroughly analyze prospective real estate investments prior to purchase? Do you inspect the property diligently looking for potential risks and downsides?

If you are new to analyzing real estate investments, you may wish to read my blog post on investment analysis to learn about some commonly used analysis measures for real estate.

2.) “Promises safety of principal”

Safety of the principal is of utmost importance in investment activity. The principal in a real estate investment is your down payment and equity in the property, up to the entire purchase price if you pay cash for a property.

So how might we ensure the safety of our principal in a real estate investment? Better yet, what are some ways that we might put our principal in a real estate investment at risk? Here are a few examples of risky activities for your consideration.

– Over leveraging the investment or paying too much for the property leading to high mortgage payments. Significant negative monthly cash flow on several properties can add up quickly and require other sources of income to support. This can be avoided through proper analysis prior to the purchase.

– Not having sufficient capital reserves. Real estate investors must have funds in reserve to deal with inevitable required capital expenditures like roof replacements, HVAC replacements, etc. This is one of the most common mistakes we see and can lead to major damage to the property due to deferred maintenance, in turn causing a negative impact to rental value as well as the overall value of the asset.

– Not taking care of the property. Investors that manage their properties on their own often times have difficulty keeping up with the repairs and maintenance of their properties, leading to a slow decline in the condition of the property. This causes a decrease in the property value as well as the rental value.

These are just a few of the ways in which the principal in a real estate investment can be put at risk. I have observed many real estate investors lose dozens of properties at the foreclosure auction as a result of some combination of the above mistakes. They may have discovered, too late, that their operation was more speculation than investment.

3.) “and a satisfactory return.”

This ties in with the first portion of the definition. It is left to the individual investor to determine what is a satisfactory return. However, I like to use some common-sense rules of thumb for determining a satisfactory return.

We know that the S&P 500 has averaged roughly a 10% annualized return over the last 25 years.

We also know that between 1965 and 2012 Warren Buffet was able to generate a compound annual rate of roughly 20%.

If I assume for a moment that a modestly leveraged (say, 65% of market value) investment property has the same risk profile as investing in the S&P 500, it follows that I might determine a satisfactory return on my capital is higher than 10%.

As a ceiling, I do not expect to generate rates of return higher than Warren Buffett, who is arguably one of the most successful investors ever. I have seen many proformas with projected internal rates of return (IRR) greater than 25%. In my opinion, it should raise eyebrows if a pro-forma shows a long-term rate of return that will beat Mr. Buffett’s average.

In the end, each investor must determine their “satisfactory return” and know how to determine if a prospective investment is expected to deliver it.

In closing, Graham and Dodd’s requirements for an operation to be classified as an investment are stringent, and all other activity should be properly labeled as speculation. Using this definition may help you answer the question: Are you an investor or a speculator?