What Value Do Real Estate Investors Bring to the Market?
Posted on August 2, 2007
Filed Under Real Estate Investing |
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I think we first need to separate investors from speculators. A speculator is more akin to a gambler or a day trader of stocks where as an investor, at least a real one, knows the fundamentals and knows how to assign value to an asset in its current state. A real investor also knows how to increase an asset’s value and what that value is likely to be after some action is taken. There is much confusion among laypeople between the two and they often lump the two into the same group.
But, they are not the same and the difference is more than just a short term verses a long term outlook.
I am going to talk about investors and what they bring to the party over the short term because they bring quite a bit. I’m not going to discuss the value an investor brings as a landlord because the metrics are different. Here I am going to concentrate on the investor who buys problem or less than desirable properties and improves them with the intention to sell them to a retail buyer.
The real estate equity market is a little different than the other equity markets like securities. In the securities arena you have market makers or specialists. These are required to maintain a certain amount of liquidity in their areas. There is no market maker in the real estate area. Some argue that speculators fill that roll but as we see with the current correction they don’t fill that roll on both sides of the liquidity equation. The speculators have left the markets suffering a downward correction and that is accelerating the correction down just like it did on the way up. Speculators actually increase market volatility.
In contrast, investors decrease market volatility. A real estate investor is not going to buy just because everyone else is buying. More often than not they are operating in the opposite mode. As a result, investors are doing a great deal of buying during this current correction but they are not buying at retail market price. A good investor buys based on the cash flow, not the market value. Even if that cash flow is as simple as, purchase, hold while repairing and improving and sale.
The most common image today of a real estate investor is the flipper. Someone who buys a property makes some repairs or cleans it up and paints a few walls then sells to a retail buyer. This is really a speculator not an investor. When the speculators started flipping things got crazy. But, investors were “flipping” long before it became known to the popular culture and they are still doing it now. But, there is a difference in how the investor flips and how a speculator flips. That difference usually results in the investor making a consistent profit while the speculator’s profits are hit or miss and more often miss.
Let’s take a concrete example.
As an investor I have certain areas I like to buy into. I know my area very well. I know my target market. I know what type of people like to live in my areas as a renter and as an owner and there is a difference. I know what amenities they want and I know what quality standards they expect. In fact, I make it a point to know my market so well that I know the preferred paint colors and shades that will increase or decrease their perceived value in a property. It is very much about perception.
I know so much about my area and market that I can look at a property and know what I need to do to maximize my profit potential. I know for example, crown molding is a given, in all rooms. If it isn’t there, I know I need to add it to appeal to my target market. But, it isn’t based on fads. For example, even though orange carpet is making a comeback, you won’t find it in my properties. That is a fad now, just like it was as shag carpet in the 1970’s. But, the choice of kitchen cabinets and appliances can make a huge difference in the profit potential of a property. So, I won’t hesitate to replace appliances that don’t match my target market’s expectations, even if they are just a few months old because it is in my best interest to do it.
So, as an investor if I buy a property and then transform that property into something desirable to my target market I have definitely added value. Part of that value may not be readily apparent because it is the knowledge of my market and their expectations. But, the value added is there none the less. If there had been a buyer willing to pay my seller an amount similar to what my buyer pays me, the seller would’ve sold to them instead of me.
There are a number of reasons the “handyman special” doesn’t play well with most buyers who want to live in the property. Not the least of which is the financing problem. A lender typically wants to loan based on the estimated fair market value at the time the loan is initiated. They are very leery of loans based on after repair value and even when they do make those loans they come with a ton of conditions. Granted the future homeowner could initiate the financing to purchase the property then fund the repairs from other sources and refinance when completed but most don’t have those kind of resources. Even if they do, that approach results in higher costs because of the ultimate refinance.
An investor doesn’t function just as a middleman. If they do they won’t be successful for long. They have to add value, it is the only way a business model really exists.
It isn’t any different than any raw material purchase used to create a finished product.
It is theoretically possible for a consumer to buy all of the raw materials in any finished product but it is not usually cost or time effective for them to buy cotton, spin it into thread, weave it into cloth and sew their own clothes. Yes, they could eliminate all of the middlemen in all of those transactions but most people wouldn’t. It isn’t cost or time effective.
The same is true for properties needing repairs or upgrades to meet the expectation of someone wanting to live in them.
Yes, in this scenario it is possible even for the speculators to add value to the market. But an investor knows their market, they know what will add value and they know how to structure the transaction to maximize their profits. There is no shame in that. The investor is there to make money on the deal. The biggest difference is the investor knows how they are going to add value and make a profit doing it, the speculator is hoping to ride the popular wave.
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