Real Estate Can Be Like Fishing In a Farm Pond
Posted on August 31, 2007
If you read the news, you know we are heading into a down real estate market, one that I predict will fall much more before it hits bottom and starts to rebound. There are many telltale signs that support this prediction. Until this past spring, I had not been approached by a builder offering to discount a new spec home in more than three years. In the last two months, I’ve been approached by five different developers trying to unload properties that they built expecting to turn quickly for big profits. Unfortunately they started construction when the market was at its peak and by the time the properties were ready to sell, the buyer had dwindled rapidly.
One developer approached me a few weeks ago about a rather large townhouse project he was building, and his story was one that could have applied to thousands of builders across the country. When the project started, the units were selling faster than they could be built. It seemed that buyers were lined up to bid on the units before they were even out of the ground. That was a couple of years ago when the market was red hot. Money was easy to come by, property values were soaring and there seemed to be no end in sight.
Now come forward to the present; interest rates have risen, credit has tightened, sub-prime loans that were responsible for fueling much of this buying frenzy have all but disappeared, and homebuyers who were looking for a new place to live have already bought. That leaves speculators who bought properties betting the end would never come, holding properties they can’t sell and builders who committed to projects still pumping product into a market that is dwindling rapidly. Unfortunately, it’s a recipe for disaster.
The developer who talked with me about the large townhouse project said he couldn’t understand how the market could just suddenly dry up the way it has. I asked him if he had ever gone fishing in a farm pond. He didn’t quite get what I was saying so I had to elaborate. I explained that a farmer could keep a certain number of fish in a farm pond, feed them, fatten them up, get them to used to having an easy meal and then if he stopped feeding they would bite the first baited hook that hit the water. The problem is, although the fishing may be excellent for a little while, when the last fish is caught, you can wear yourself out casting baits in the water and not even get a nibble.
To a degree, the real estate market is much like the farm pond. In any given area there are a certain number of buyers for a particular type of property, but once those buyers have been satisfied, building more product doesn’t make a lot of sense until the market has a chance to digest what it has consumed. What makes real estate different from the farm pond, which usually has no stream flowing into it, is that people are transit and even though a market may be “fished out” today new buyers can arrive tomorrow. It’s the anticipation of this happening that causes builders to keep building and speculators to keep buying.
Low interest rates and easy credit does for the real estate buyers what care and feeding does for the fish in the farmer’s pond. An exciting new development (bait) starts up in the area and speculators jump on it (have a buying frenzy). The real buyers, the ones who want to make a home there, are quickly accommodated and then as interest rates start to rise and credit get tighter, the frenzy dies off quickly and the speculators are left holding the bag. This may be an oversimplification, but it’s the way the real estate market works and what makes it ebb and flow just like other financial markets do.
Here’s a tip! If you’re buying a home in which to live, you can never pay too much if the joy and happiness it brings is worth more to you than what you pay. However, as an investor looking to build an income stream with rental real estate you have to look at things entirely different. If you buy with the sole expectation of selling later for a profit, if you are betting on appreciation to bail you out of a bad deal, you’re setting yourself up for disaster.
Real estate is a great way to build wealth when you approach it sensibly and are patient. It’s a great way to lose a fortune if you get caught up in what I call The Greater Fool Theory. This is the euphoric frenzy created by a red hot sales market. I call it The Greater Fool Theory; because when people reach the point where they think prices will continue to soar they start to think that all they have to do is buy, at any price, and a greater fool will come along and buy from them at a profit.
Unfortunately, investment real estate is only worth what the income it produces will support. Any other way of looking at it is not investing, it’s speculating and as the developer with the big townhouse project is learning, when people speculate, some win and some lose.
If you want to speculate, that’s fine. Some people like casino gambling. My advice to speculators is the same as it would be to the gamblers. Don’t put money at risk that you can’t afford to lose. The more the market looks too good to be true, the better the chances are that it is. Be sure the fish haven’t all been caught before you buy the farmer’s pond.
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