Real Estate Investing: It Can Be Lucrative, But So Are Ponzi Schemes

Another day spent closely reading the real estate section, another gem… Sunday’s local Times included this piece from the Philadelphia Enquirer that noted the large number of bank-owned properties on the market and the likely buyers of those properties: investors. Its a hot topic, and this article makes some good — although hardly disputed — points. But here’s my favorite passage:

Nationally, investors gobble up more than half of the bank-repossessed properties. “Most are rehabbing and renting them quickly to obtain a positive cash flow, then refinancing the property and taking the cash to buy another one,” Sharga said. They are looking at three- to five-year investments, he said, “so the current short-term depreciation of real-estate values isn’t a big deal.”

Other investors are doing wholesale flipping, Sharga said, buying “the most absolutely discounted properties, doing minor repairs and flipping to another investor, buying 20 cents on the dollar of the last sale price and selling for 50 cents.”

I added the emphasis, needless to say.

This raises the following question in my mind: Was Mr. Sharga laughing when he said this? Or maybe wearing a clown suit? I mean, what investor in his right mind says that you don’t have to worry about short term depreciation of the asset at issue if you intend to sell WAY off in the future — like 3 years! Even stock brokers will tell you that a 3-5 year investment horizon is relatively short and does not lend itself to risk. A depreciating asset at the time of purchase, to be sold 3-5 years down the road, should be a MAJOR concern to any investor. And that ignores the reality that transactional costs for real estate (taxes, commissions, escrow fees, insurance fees) are much higher than equities. Its a pretty absurd comment — but it will likely entice somebody to “invest” in real estate.

And why would that be important to Mr. Sharga? He spills the beans in the very next paragraph. At first blush, it sounds like these investments are fantastic: Pay 20% of “true value” — whatever that means, its another pet peeve of mine I’ll address in a future post — invest a few bucks, and then sell for 50% of value. That’s greater than 100% profit, presumably in 3 years or so! But here’s the catch: you gotta sell to “another investor.”

So this profit relies on pulling new investors into the market all the time, presumably those that don’t appreciate the fact that they’ve already missed the boat on the easiest profit. As long as those new investors are there to buy, the investors further up the pyramid… er, I mean supply chain will make great money.

Thinking of becoming a real estate investor? Yes, it can be lucrative, but be careful. And don’t believe everything you read.

22 thoughts on “Real Estate Investing: It Can Be Lucrative, But So Are Ponzi Schemes

  1. Sadly, many of the real estate guru’s that people in the r.e. biz and public clamor over never ever discuss risk when buying r.e. Most authentic real estate investors I personally know 1) purchase for long term cash flow and 2) have very long holding periods (typically held in Trusts) and lastly 3) buy the property with cash or exceptionally low LTV if financed.

  2. I don’t think 3-5 years is indicative of the average holding period for all real estate investors, at least I certainly hope not. Many investors are buy and hold types who keep their investments for decades.

  3. Well said Craig! It is definitely a risk, even in a good market, to be a real estate investor. Sounds like a good ole fashioned pyramid scheme to me… as long as you can find 5000 people that are dumber than you’re, you’ll be rich. lol

    • Flippers are in a sense “market makers” and serve a useful purpose in the marketplace. I have no problem with them to the extent that they are market participants.

      The problem isn’t that they exist — hey, humans will find and exploint ANY market niche — its that they often turn around and trumpet the “opportunity” presented by real estate investing. This rank promotionalism is really self-serving, as flippers are successful largely because of the next investor in line — who almost certainly will not do as well. So its this “ponzi scheme” aspect of the flipper business that I find problematic. Its not the people who are buying and selling that are the problem, its the people — sometimes the same ones to be sure — who promote real estate investing as a “can’t lose” fantastic business opportunity. The flipper PROMOTERS are the ones who are the problem.

  4. Well that’s just not true. Flippers, along with home ownership, got out of hand for a very short period of time. Building, and land development actually contributed the most to bubble. The loans associated with housing development, or development in general, added trillions of dollars to the bubble. The ability to sell securities based on promises to pay is what really made the bubble what it was.

    I’ve got to go to work, but didn’t want to leave these comments hanging.

  5. What I do is better described as restoration, but most people don’t want to pay for that. We are well versed, and that includes some fine people who have been with me a very long time. I was grateful for the run up in Real Estate prices because it gave me an opportunity to do what I wanted with properties that we owned, and controlled out right.

    In most cases, as my friend Dan would say, I had other people buy properties for me. No one would give me a loan for most of my life. What we do is very high risk.

    To even begin a discussion about flippers you would first have to grade properties to have a basis. Some properties are a toss up between tear down, and fixer. It’s an art to know the difference. Next you would have to separate out systems, and where they are in a usability category. After that is the design, then finally cost of what needs to be done, as opposed to what will add value.

    This is the most complex of Real Estate transaction. It is also the heart of Real estate because all Real Property deteriorates. All property has a point of obsolescence. The flippers add life to property, give longevity, and keep the market place moving.

    Let me also say, as I have a thousand times, in front of a lot of people, “everything you have ever heard, or seen in an infomercial is absolutely true.” The reason there are a whole bunch of tapes that come with the work book is because it is a complex business.

    For those who follow the principles, work hard, and expect to make a great return there is a lot of money to be made. If you think you will get rich quick you will be disappointed.

  6. You know Jerry that architects are ten time worse. Town houses were brought to us by an architect who provided the plans to a builder who figured out a way to maximize the land use zoning for density. I met the guy, he showed me the plans, and a Real Estate agent with a big local brokerage promoted the scheme.

  7. No it’s not Jerry, not every one is you. Architects are kind of like lawyers, you go to them to find the angles.

    The flipper thing has come up a lot since the bubble has been discussed. I think more of that has to do with condo conversions than anything else. From the investment stand point most of the guys I know have been pretty up, and up. You do run into those that bought the tapes, and think they are winning only if some one else is losing. They are pretty few, and far between. you get that in any business however.

    Most flippers deal in junk. They are like a Goodwill, or a junk shop. They have pickers or they research the deal. Some drive neighborhoods, or send out letters, some are at auctions, or look at the NWMLS. It’s hard work, and high risk. You have to be able to sell to flip. Some times you make money and some times you lose.

    Housing development on the other hand found dirt prices in wetlands, farm land, on the ridge at Issaquah, affordable housing sites, and any dirt that was cheap. By a financing plan that was designed at driving up the price to the highest margins they built, sold, and created the mortgages to be sold. The finance package was the ultimate money maker and banks were more than happy to play along. Even after the crash Sterling Bank was offering those 4% loans that are now being sold.

    The same thing happened globally. Housing, and Real Property projects are built everywhere in the world with the same financing schemes. Some are sold other play a default game to lower pricing, but the loans have already been sold.

    I think we all need to come to grips with the fact the Real Property industry has changed, it will never go back to where it was, and debt is the true prize of the banking industry. Real Property just became another debt vehicle.

  8. 3-5 years!!!!!!! thats a nightmare for all our partners at Data Snap and Vestus. In fact if you hold longer then 6 months you most likely bought a rental –the worsty nightmare for investors diving into this mkt. I’m in the midst of 3 flips currently all bought for 50kish in South Tacoma/Spanaway and will hit the markets in about 30 days for 99k. My partners like the 130k flippers in Puyallup, Graham, and Auburn. They tend to sell for 180k-200k.

    Many investors use hard money locally at 12% and 4 points with 9 months to move your purchase. You must establish your escape plan prior to purchase and have your 20% down ready and 640 credit score so they can throw u into a rental loan in case you over spent on fixing it up. Either way you are now a bagholder.

    Caution to all investors using hard money. They will gobble up your property back in short order if you make an error in judgement and I see it week after week at Trustee Sale with properties going back to the hard money lenders..

    • Ah, that’s the pitch! Get in, get out, make your money and don’t be a — gasp! — “bagholder.” If you hold the property longer than six months — OMG — you’ve become a landlord, the “worst nightmare” for “investors.”

      In other words, Ray, your business model falls squarely within the “ponzi scheme” structure I discuss above. You make money ONLY BECAUSE some less savvy sucker believes the motivational speaker who said that real estate investing is Can’t Lose Easy Money! You buy, fix, and unload the asset to that suck… er, buyer/investor. What happens then is his problem. You get to move quickly to your next “flip.”

      I get the upside of what you do — see above — but it also relies on constant stream of investors dumber and less savvy than you to work. And that’s a little shady, don’t you think?

      • well no pitch here. its just what we do. motivational speaker? not sure what planet your on.. It takes many hours to find these homes months after months …state after state…. We have different understanding on the types of investors there are out there.

        the last one we just closed on was 50k in tacoma. it will be listed for 99 or 105k…will take 10-15k in rehab and we emply MANY people who would have otherwise been on unemployment or??. Its in my opinion we do the community good if you would have seen what the home looked like before. In addition the person who buys it will have a payment of 800.00 about 100.00 less then it would rent for (4 bed 1 bath). Thus, we make a NEW homeowner and a great property tax payer to help this wonderful state.

        See Craig, we MAKE new home owners at prices that make sense compared to renting. We don’t make alot of money per house but the money is in the numbers. One mistake and in this case paying 70k for the home and expecting 125k and you just bought a rental. The “nightmare” of an investor.

      • Craig, you should stick with law.

        Holding property today, or a buy and hold, would be a net loss. It would destroy our economy. If Ray wants to pay way too much for property that is his business. $50K in Tacoma seems like a lot of money to me. Some one paying $100K for a place in Tacoma? well that must be a palace, with a view.

        Property prices will be dropping for a long time. Some properties are worth keeping, but many are complete junk. There is a lot of new construction that just needs to be bulldozed, and the land sold so something can be built on it.

        In other words you really, really need to know what you are doing if you are buying a property today.

        Having some one like Ray, and his buddies do the picking is some times the best way to go.

        • David, just always have the best deal in your zip code and utilize the cost to own/rent ratio and you will know when you have a GEM. But, be prepared. We get rejected 9 out of 10 times. Its that 10% that make it all worth while. On the last two we had 3 offers on each within 12 days on the MLS.

          We have been red hot with Estate sales lately. More luck then anything but my god they have been signing them away. Trustee sales are becoming too popular with all of the Eastside Funding money and allowing too many novice investors to over pay with their 20% down. Craig would be eaten alive or be a “one and done. ” I see it over and over.

          However, the Buyers you can never outbid are the owners buying under an LLC or people who wanna secure a rental. These people will always outbid us and now I just phone in our bids and listen live. No more sitting in the rain with all the buffoons and listening to the dog and pony show.

          • OK, I’ll fill up the reply boxes with: “you must be brain dead to be buying in this market!!!!!”

            At the end of June the Quantitative Easing will be run to ground, by the end of this year, or next at the latest, China will be tapped out. We’re already seeing big investors deleveraging into cash. CitiGroup is back to losing money.

            All of those new land lords will be wishing they had held out just a year longer before they bought.

            Banks are in a hey day of generating cash to be in a liquid position. Within six months, or when they feel this selling season has run it’s course they will start dumping properties, prices will drop, and then they will begin modifying loans rather than let people off the hook.

  9. David there are ALOT of people making ALOT of money flipping homes. ALOT! They buy well below what the REO’s list them for and turn them quicker then you can take your trip to Peru. You can sit on the sidelines and wait or be ahead of the curve. you don’t have to look any further then the price of gold and silver to know the darkest days are yet to come. However, they are not for years yet. The worm will turn well after next year and the best you can do now is position yourself.

    My brother owns the Gold and Silver Exchange in Texas. People are flooding into his store buying gold and silver daily. When people pile in..its always time to get out.. Its well known silver will be hitting north of 50.00 with all this momentum and I know he will have sold all his metals when this happens. Where will he go? Currency?–never..The market–no way. The most beaten sector–housing…The sector that the Fed will want to stimulate for years to come. Where the cost to build will be 4-5x the asking price.

    Just hope the Fed sits on their hands and does nothing. This will give us all time to build a portfolio that will take us into retirement over these next 10 years and you can sip your Pisco Sour with your legs up each and every day.

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