Q&A: How do you ensure a property purchase will add to personal wealth?
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When buying property to rent out, or even just buying a home to live in, how can we make sure the purchase helps us to generate wealth instead of becoming a load to bear?
This is a complicated question, and one that’s closely related to our last Q&A post about investing versus speculation.
When someone buys a property as an investment – meaning they intend to rent or sell it at a profit – they might be thinking they’re adding to their personal wealth. However, this purchase can easily turn speculative if the buyer hasn’t done enough due diligence to ensure their margin of safety is high and uncertainty is relatively low. You must look at the property’s valuation in a larger context and then make sure you understand if there are legitimate reasons for any changes in that valuation.
Say you're buying a beachfront property after a five-year period of prices going up faster than the consumer price index (CPI, a measure of inflation). That rapid appreciation might look attractive at first glance, but at a minimum, you should understand why that's happening. Maybe it's due to a perfectly legitimate reason! But sometimes nothing's really changed, and it’s just a matter of time before the rug gets pulled out from under that overvalued property.
These kinds of investments are very subject to “reversion to the mean.” This concept is a very powerful dynamic that almost everyone underrates, none more than speculators. When the market’s hot and prices are soaring, people get excited and want to get in on the action! But you can usually expect a correction at some point that brings prices back down to earth and closer to the mean price. That can land you with a property that cost too much relative to its real value, leaving you unable to earn back your investment, much less generate new wealth.
Ultimately, in real estate, you create wealth in two ways:
1. You make money off the current income (if you charge rents or sell a property outright).
2. You make money off price appreciation (which is how people use their homes to build wealth).
If you're making less than your investment from current income, then more of your money-earning potential depends on prices going up in the future. If you buy at $100,000 and make $10,000 in gross rents, you’re in a better situation than if you bought the property at $200,000 but can still only charge $10,000 in rents based on current market value.
So, if people suddenly decided they’re willing to pay $500 a square foot for that beach property, whereas previously they were fine with $300 a foot … why? If something legitimately and permanently changed that made it worth $500 a foot, that's fine. But otherwise, that purchase begins to look a lot more speculative.
This also means, by the way, that real estate purchases used for wealth building follow the same basic principles of “buy low, sell high.” I addressed that idea in April’s Q&A. There, we were discussing buying assets like stocks rather than real estate, but my answer largely still applies here:
“I wouldn’t buy based [solely] on a hard-and-fast rule of ‘buy low, sell high.’ I’d be buying because there are clear indicators that market price is low relative to intrinsic value and that growth in value is likely.”
In other words, it’s smart to buy real estate that’s underpriced relative to intrinsic value and not smart to buy if it’s overpriced relative to intrinsic value.
That said, it’s a little different when someone buys a home to live in. Here too the buyer might want to add to their personal wealth, and it’s obviously possible to make bad home buys, but I’m not sure “speculation” is exactly the right term for this situation. If you find a house and you plan on living there for the long term, and assuming you're not massively overpaying, then I would advise people to just use common sense. It's hard to really put a price tag on things like neighborhoods, school systems, and the joy of living in a home you love.