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The Real Estate Crisis and the Greater Fool Theory

By Mike Summey
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Pick up a newspaper or turn on the television; you will be bombarded with stories of doom and gloom blamed on a crisis in the real estate market. Can't anyone see the real problem? The collapse of the real estate market may be contributing to high oil prices, bank failures, the sagging economy, job losses, and other economic problems, but the reason for the downfall is simply greed. Speculators, relying on the Greater Fool Theory, bid real estate prices up to unrealistic levels and leave the last ones holding the properties facing huge losses.

In case you're not familiar with the Greater Fool Theory, it's a phenomenon that occurs in all financial markets, not just in real estate. It starts when a few savvy speculators buy stocks, bonds, real estate, or other investments, and then sell them in a relatively short time frame and make a huge profit. Other not-so-savvy speculators then try to get in on the gravy train. This begins a flurry of buying and selling based on the theory that it doesn't matter how much you pay, a greater fool will come along and pay you more than what you paid.

As additional speculators enter the market, it precipitates a frenzy of buying that seems as if it will never end. Guess what? It does! Then when the market collapses and prices fall, the fools who bought last start crying for help. The savvy ones, those who started the whole mess, have probably taken their profits and moved on from speculating in real estate to speculating in oil. What makes the real estate collapse a crisis is that it has engulfed average working Americans who just wanted to buy a home. These people now stand to lose everything.

Greedy lenders are as much to blame as speculators for enabling ordinary people to become ensnared in the euphoria of rapidly rising home prices. Subprime loans, interest-only loans, undocumented loans, home equity loans, and lines of credit that could bring financing to more than 100 percent of appraised values, all contributed to flooding the market with cash that couldn't be justified. Adjustable rate mortgages (ARMs) with low introductory rates enabled individuals to qualify for loans they couldn't afford.

This easy money attracted more buyers and super-heated the market. Prices were rising 10, 15, 20 percent per year or more in several areas. In a few markets, buyers were making offers that were higher than asking prices, and sales contracts were often signed the day a property went on the market. Unsophisticated buyers armed with easy credit jumped on the bandwagon, and their exuberance enticed builders to flood the market with condos and spec homes. That's when the Greater Fool Theory finally hit full throttle.

Anyone with a little common sense could see that this was a recipe for disaster if they hadn't let greed cloud their vision. From individuals who bought properties they couldn't afford to lenders who loaned them the money to do it, all were at fault. Finally, the bubble burst, prices began to fall, builders who couldn't sell their inventories started going under, homeowners defaulted on their exotic loans, and lenders were flooded with foreclosures. Those left holding the bag were the greater fools.

I've experienced four of these boom and bust cycles in the real estate market, and I'm happy to say that I've never experienced a down year. The reason is simple. I don't participate in the Greater Fool Theory. I'm an investor, not a speculator, and have been for more than 35 years. The difference is easy to define. With the exception of your primary residence, if you have to sell a property to make a profit, you're a speculator, not an investor. Investors invest! They buy and hold for the income stream an investment will produce. Speculators buy in anticipation of selling for a profit. Most speculators consider themselves investors until prices fall and their speculative purchases turn sour.

We're entering a period of correction in the real estate market. Investors stand to build tremendous wealth during this period, and speculators will lose their shirts. The current real estate crisis is creating great opportunities for those who know how to evaluate and purchase real estate investments. Whether you're looking for a home in which to live or ones with which to build wealth, the coming months will be a fantastic time to buy.

Here's a tip! You wouldn't go to the bank and buy a Certificate of Deposit that you had to pay interest on while you owned it; likewise, you should never buy an investment property that you have to pay for the privilege of owning. Unfortunately, that's what many people do. They get the false notion that appreciation will bail them out of an otherwise bad deal, but it just doesn't happen. Real estate may have created more millionaires than any other investment, but betting on appreciation has probably bankrupted more people than any other investment.


There's only one safe way to buy real estate as an investment. You first estimate how much gross income a property can produce. Then reduce this amount to allow for vacancy between tenants, to arrive at a realistic net rent. Then subtract all anticipated expenses from the net rent to arrive at a Net Operating Income (NOI). Unless you can structure a deal that lets you buy with the NOI, it's not a good investment. It's that simple!

If you're buying a home in which to live, your earned income should determine what you can afford under normal market conditions. Don't be enticed into buying a bigger home because you can get an interest-only loan or an ARM with a low introductory rate. By following this advice, you won't get in trouble and you can take advantage of the current situation to secure your future.

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Close the doors. Be fearful when others
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Warren Buffett
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