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Real Estate: An Inefficient Market

By - April 22, 2013

The best investors on Wall Street lose money on an investment regularly. They may make a profit more often than they lose, but losses are regular, at least in the short-term, because the stock market is what's referred to as an efficient market. In such a market place there are enough people involved and almost all relevant information is widely available. As a result, the price of a share of Coca Cola is the same all over the world (give or take a penny).

In an efficient market it is difficult to predict what the price of something will be in a year. This is because anything that might affect the price is likely to be known by enough investors to be taken into account in the current price. Think of it this way; if the price of gold (another efficient market) should be at $2,000 per ounce in a year for reasons that are widely known, why would it be selling for $1,600 now? Buyers would be thrilled to get a 10% return and so would pay at least $1,818 per ounce. In fact, if the price was $1,600 per ounce and even a few smart investors "knew" that the price would be $2,000 in a year, wouldn't they borrow heavily at today's low interest rates to buy as much as they could, thus pushing the price past $1,800 by the end of the day?

It's tough to make money in the short term in an efficient market (Warren Buffet, perhaps the best investor of all time, buys only for the long term, without concern for where prices will be in a year or two).. But real estate is an inefficient market, one where information on a particular property is not necessarily widely available or known, and where there might be very few buyers. The latter is especially true of certain types of property.

For example, an ugly house might have only a few people interested in it, and each might have a different idea about the value. And unlike a stock, where all investors can easily read about the latest earnings report or company scandal, for a given house perhaps only one buyer investigated and discovered that a new bus line is going to pass in front of it, making it possible to rent it for $100 more per month and thus adding more than $10,000 to the value. In the latter case, being the only bidder who has this information, he can perhaps easily out-bid the others and still have a good buy.

Real estate is different in other ways as well. In efficient markets the goods are easier to compare. Even companies in different industries all report earnings in a similar way, and either pay a dividend or don't, and have publicly available records of their past prices. And, of course, any share of Microsoft is the same as any other. But houses that are even in the same neighborhood are never quite the same, and are more difficult to compare. Does a larger garage add $2,000 or $6,000 to the value of a home? Are south-facing picture windows better than a screen porch facing a backyard? Each home is unique, so all comparisons are really just "best guesses," even for expert appraisers.

The result of this inefficiency is that experience and the intuition that comes with it matters much more that in efficient markets. If you randomly buy a stock with no experience, you get it at the price that all of the experienced players have determined with their purchases and sales, making you almost as likely to succeed or fail as a veteran of the markets. But with real estate, whether rental homes or strip malls, what you have learned and practiced matters. With experience you can develop an eye for what will sell or rent easily, or for what kind of buyer you will need if you are "flipping" a house.

Furthermore, that uniqueness of each property makes it possible to use creativity in both buying and selling. Suppose you are buying a rental house during a time when interest rates are high. A seller might be willing to finance a deal at a lower interest rate if you know how to explain the advantages and offer a higher price. You may have learned from experience not only how to persuade a seller, but also how to structure the deal so that even when paying a higher price you increase cash flow because of lower payments.

On the selling side, you have options. If you want to sell some stocks in your IRA you sell at what the market determines is the current price. But if you want to sell a house you can fix it up, add a bathroom, offer financing or do any number of things to try to get a higher price. You could even move into your rental home for two years in order to sell it without paying taxes on the gain. You have much more control with real estate than with most investments.

You can even change the purpose of a property. For example, we recently bought a rental and decided to sell it for a profit after some difficulty finding a tenant. But beyond that, you can sometimes make bigger changes, like converting a duplex into a single-family home of vice-versa, according to what is hot at the moment.

The bottom line is that with an inefficient market you have a chance to get an edge on other investors. That's what makes real estate so interesting.

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Houses Under Fifty Thousand | Inefficient Market