Not long ago I wrote a post on Real Estate Speculating vs. Real Estate Investing. My main point was that  speculating and investing are two different activities which require two different skill sets and risk appetites. Either might be right for you, but the danger comes when you think you’re doing one but you’re actually doing the other.

At least that’s the point I wanted to make. But it would appear from some comments that my post was interpreted as bashing speculators. That’s not my view.  Sometimes you gotta roll the dice. 

So today as we stand in the shadow of Enron and the collapse of the dot.coms and foreclosures pop up all around us like mushrooms who in his right mind would try and defend the defamed speculator?  Well...I would.  Risk and reward are correlated in efficient markets, so there's nothing wrong with taking a risky position if you know what you're getting into.  So..here are four points that I like to keep in mind when it comes to speculation:

• Buy what you know: Ever had someone tell you “my brother’s roommate says that nanotechnology is the next big thing…and here’s a penny stock in the sector that’s about to go through the roof!”   That's bad advice, probably. Take your money and go to Vegas instead – at least you’ll have some fun in the process. However, taking a speculative view in a market that you know intimately is a different proposition. Example: I recently bought a fourplex that had yielded a decent return, but the real reason I bought it is that I’m bullish on the neighborhood, and I expect that the city might announce a light rail station a block away. This was a speculative view, but it’s a risk-reward that I’m happy to shoulder.  I know the market.  I know the risks.  And I accept the trade-off.
• Be ready to lose: Speculators win big and lose big. Gambling your retirement on a speculative position is silly. Having some speculative purchases in your portfolio is a good diversification strategy, in my book, but don’t bet more than you’re willing to lose. USA Today wrote a goofy article recently about real estate investors which was really about speculators. It was full of misinformation, but it did highlight the fact that people sometime do foolish things when it comes to real estate.
• Flippers are speculators, not investors:  Well, most of them are. If you have mastered techniques that allow you to consistently buy at 20% below market value then you have a strategy that’s fit for all seasons. But by now most of us have noticed that the flippers come out of the woodwork during a bull market and they disappear back to their day jobs once the markets correct and cool. Why is that? It’s because flipping in inherently a speculative activity. Here’s a news flash: it’s not the tile that you put in the foyer or the paint job that added $50 thousand to the price of that house you just bought and flipped; it was the rising market. In a falling market you can’t make money making cosmetic improvements to an ugly house.
• Buying in an overheated market? You’re a speculator:  Here’s a test – do you need a double digit rate of appreciation to get a decent rate of return on a property? If you’re buying right now in most areas of California, Florida, and a lot of other hot markets then that’s going to be the case. If you’re investing in a property that doesn’t immediately yield positive cashflow then you’re betting on a rising market. Again – that might be okay – as long as you realize that’s what you’re doing.

So here’s to the real estate speculators - at least to the prudent speculators who don’t get in over their heads and don’t bet more than they’re willing to lose. But with investors suing to back out of underwater deals and states like Massachusetts taking measures to protect overleveraged investors from foreclosure  it would appear that prudent speculators are outnumbered by the get-rich-quick guys who get themselves in trouble.

But that’s okay…a rash of foreclosures just means more distressed below-market properties for smart investors to scoop up.

The media scares me. We all rely on journalists to make a big world small and help us digest current events, but whenever I see an article on something that is within my area of expertise – like energy policy or real estate – I’m often appalled at how badly some publications mangle the facts and principles in order to spin an entertaining story.

The worst offender among the popular press, hands down, is USA Today.  Check out the feature story on Real Estate entitled Many Investors Feel Like Running Away by Matt Krantz.

If you take this article as light entertainment – kind of like reality TV – I guess an article like this might be relatively harmless. But many people go to USA Today for information – and that makes journalists like Krantz dangerous.

Where to start? Well here are some of the more egregious flaws in the article’s reasoning:

Cash in the stocks, baby, we’re buyin’ real estate! The article states that the current market is “a complete flip-flop from 2002, when investors tired of the bear market ravaging Wall Street cashed in their stocks and bought homes and investment property.” This is goofy. Smart investors might tilt their investment portfolio more heavily in one direction than the other, but it doesn’t make sense to flip your life savings from one asset class to the other in an effort to catch a hot market.  Articles like this treat investing and speculating as interchangable concepts.  They're not.  

Taxes, toilets and tenants! For some reason, the popular press loves to exaggerate the pain and suffering that landlords go through. USA Today comments that “wannabe real estate tycoons stuck with properties they can't sell have been turned into landlords, forced to fix toilets and take tenant calls in the middle of the night.” Ok – show of hands – how many of you landlords are running out at 2 in the morning with a plunger in your hand? Note that these articles are written by journalists who don’t know anything about investing – take their advice at your peril.

Stocks have always outperformed real estate! The article suggests that real estate investors who are underwater now could have “shaved themselves some trouble if they had done some research,” pointing out that stocks have appreciated at a faster rate than real estate over the short and long term.

That's silly.  The source neglects many key factors about real estate and stocks.  Here's two of them:

• Leverage: the gains that you realize due to the appreciation of your real estate investment are backed by the bank’s money via a mortgage. Unless you’re a mega-aggressive margin investor, your stock portfolio is backed primarily by cash out of your pocket.

• Cashflow: The article points out that the average new home has appreciated from $4,030 to $276,400 from 1920 to 2006, a rate of appreciation that does not beat the stock market. However, this doesn’t consider the fact that real estate puts cash in your pocket. That $276k in investment properties that were purchased decades ago would be free and clear of a mortgage and would be generating from $30,000 to $35,000 per year in rental income. Compare that the dividends that an equivalent portfolio of stocks would be generating.

An interesting note: the article quotes Nigel Swaby, who’s hooked up with that iamfacingforeclosure.com guy. You’ll often see Nigel’s comments on various forums giving “advice” to investors on getting rich, but from his quotes in the article it appears that he’s sitting on the sidelines.

The bottom line: USA Today is fluff. But it’s fluff with an audience: 5.2 million daily readers. That’s a lot of bad information soaked up by a lot of people. And it’s not just the USA Today that gets basic concepts wrong; lots of other publications are just as bad.  It’s up to all of us to be discriminating consumers of information.

But here's the good news - and it's something you know already.  All markets are cyclical, and misinformation like this is great for spooking the herd.  That can be a good thing; keep your eyes open for buying opportunities.