The basic economics education that most of us received in school and from our parents programmed us to believe that great deals are too good to be true. On that basis many people lump real estate investing with other get-rich-quick schemes. Nothing could be further from the truth. Real estate is a science, a little bit an art, but it is never magic.
I try to read at least one economics book each year in my professional reading. This year I chose “Naked Economics: Undressing the Dismal Science” by Charles Wheelan. Wheelan provides a perfect case-in-point. The title to Chapter 7: “What economics can tell us about getting rich quick (and losing weight, too!).” There he describes a fictional scenario about buying real estate that really illustrates the mind-set of a lot of people and their fears and apprehension about real estate investing.
In his attempt to explain why get-rich-quick schemes don’t work, Wheelan describes a scenario in which a home buyer is trying to find a property in a specific neighborhood. In his scenario, the average single-family home in the target area is selling for about $500,000. Some sell for a little more and some for a little less depending on amenities but they’re all pretty close to that average cost.
After his fictional buyer searches diligently, they stumble upon the deal of the century: a beautiful home that meets all their criteria and the asking price is only $250,000. The buyer can’t believe it. The deal seems too good to be true but their real estate agent assures them it’s a great deal. The buyer’s investigations into the home reveals no structural deficiencies — it is perfect. The buyer closes on the deal and then resells it for $500,000 in six months, thereby doubling their money.
Wheelan goes on to explain three main reasons why this will never happen in real life:
- No seller is a big enough “Moron” to give up that much equity. And if he/she is too dumb to know then an agent, friend or family member will tell them.
- If it really were that good of a deal the real estate agent would snatch it up.
- Other buyers will swoop in and bid the property up to market value.
Wheelan’s conclusion: “There is virtually no chance that you are going to get a home at 50 percent value (without some surprise lurking in the basement.) Why? Because of the most basic idea in economics. You are trying to maximize your utility — and so is everyone else. In a world in which everyone is looking to make profitable investments, no one is going to leave $250,000 sitting on the table.”
Wheelan describes the mind-set of most everyone in the world when it comes to real estate investing. Yes, in 90 percent of situations the seller is going to sell for the absolute best price the market will give. I’m a big fan of economics. However, motivations differ and motivations drive decisions. Sure, most people want top dollar but a small minority value other things such as convenience and privacy. A lot of people think that a seller must be distressed but that’s not the case. It’s been years since I bought a distressed property. They’re normally too difficult and often involve bank approval, which is a nightmare.
I bought a home about a year ago from an amazingly nice lady. The home was beautiful. It needed work. I figured about $100,000 to bring it up to the top of the market but a buyer could have made it livable for maybe $10,000. I told her that if I were her real estate agent I could get her $850,000 for the home completely as-is within 30 to 45 days. I told her I could buy her home, but I could only pay about $720,000 cash and I would close within seven to 10 days.
She took my cash offer and was very happy with it. Why would anyone do that? I have no idea. She was a professional woman and business owner who did very well financially. When it really came down to it I think a big motivation for her was she didn’t want a bunch of people walking through the home insulting it. A lot of real estate investors and agents seem to love to tell you how ugly your home is. Imagine telling a mother that her baby was ugly before you tried to make a deal with her. Yeah, it’s almost like that.
The deal turned out wonderfully for me. I put about $120,000 into the home and ended up making a profit of about $130,000 when I sold it about five months later. Some deals, the best deals, really are too good but still true.
I can’t count the times I’ve had someone look at one of my past deals, saw what I paid for a property and say, “Well yeah, that deal is a no-brainer.” Well great, because I’m always looking for partners and investors to help me fund deals. So on the next deal I might call that same person and say, “Okay, I’ve got this property under contract — are you interested in partnering up on it?” Most of those same people will talk themselves out of the deal as too good to be true. On that one simple, deeply rooted lesson, they convince themselves there must be something wrong with the property that we are missing.
There’s no doubt that something may have been missed. But it also just might be a really good deal. The fact is some sellers are motivated by different things than most. Are they motivated to sell cheap because they need speed or want convenience or because there’s a major problem with the zoning? The buyer is at an informational disadvantage. The buyer is not going to know as much about the property as the seller and you’ll never really know for sure what motivates the seller. I always ask why the seller is selling but I take the answer with a big dose of skepticism.
So when my investors ask me why they’re selling so cheap I tell them the answer I was given but I also tell them I don’t really care. I just care if the property is a good deal given the results of our investigations. Luckily, real estate is public record. Proper due diligence can uncover most of what you need to know. Pricing and negotiation can provide a risk premium for the things you can’t know.
Yet our programming stops most of us from investing in real estate and compels us to hand over our entire life savings to financial planners or fund managers who invest in companies so massive we could never know a slight fraction of how and why they’re a profitable investment.
Our programming teaches us that wealth is not achievable for the common folk and we stay away from real wealth building activities or if we do pursue real estate investing we let a snobby real estate agent tell us that we can’t get a real deal on a property.
The traditional rules are safe and easy. If someone offers to sell you a $10,000 watch for $5,000, then traditional training teaches us that’s a scam and that traditional training will save you from being scammed nine out of 10 times. There are not many bets safer than 90 percent. However, wealth building is not safe and it’s not easy.
I have huge respect for Wheelan the economist. He is clearly much smarter than I am and his point is absolutely correct as presented. A real estate investing lesson starts the exact same way as the scenario in the book, but the caveat is sometimes you do find a great deal.
The slippery slope for most of us is to let go of those safety rules of thumb without becoming a mark or a sucker for someone trying to unload a problem house.
Justin Pierce is a real estate investor and real estate agent who regularly writes about his experiences buying, renovating and selling houses in the Washington area.