By Lois A. Vitt, Ph.D.
A major principle to keep in mind when considering whether to become an investor in housing is risk tolerance. To answer the question of your risk tolerance level in home investing consider the factual information: Your age, income, experience, savings, future need for cash, and investing time horizon. They are important considerations to realize about yourself.
Also give some time to consider other realities like market timing, mortgage interest rates, inflation, credit availability and rental and selling markets, over which an aspiring investor has no direct control. Like buying stocks “on sale” in a down market, a savvy real estate investor can decide whether a fluctuating marketplace in housing offers investment opportunities that are simply unavailable in a marketplace that is roaring upward.
If we listen to the experts in real estate investing, emotion should be locked out for investors in second homes. “Gee that is a gorgeous home—just look at that view,” is not appropriate, they might say, until after you’ve run the numbers and made an informed investment decision. In other words, don’t “fall in love” with your investment real estate until it has earned its way into your affections. Love of a home or other residential housing, however, does sway many second home purchasers and this type of emotion can lead to serious mistakes.
The same excitement, anticipation, and anxieties are often present when buying a second home, especially if its purpose in our lives is to bring relaxation, recreation, and social enjoyment as a place for vacationing. Still, the cautions that exist in our primary home purchases must also be present when considering a second home. In addition, lessons from the psychology of investing in the capital markets also apply to investing in real estate as written about by David Dreman in his book “Investor Overreaction,” and Richard A. Geist in “The Emotions of Risk.”
- People in general are over-confident when it comes to their estimates of the earnings potential of their investments. Of course there are always nice surprises, but chances are that you will be overoptimistic about the investment potential of your second home.
- In real estate, like the stock market, people forget. Not only are homeowners overoptimistic about the prospective price appreciation of their homes, analysts and other experts are overoptimistic about general market trends.
- The evaluation of risk, by definition, contains important subjective elements and considerations. It is not purely rational, nor can it be if we are to be helped in our investment evaluations and decisions by our “emotional intelligence.”
- Fear and greed are the psychological concepts that drive the markets it is often said, but psychologist Lola Lopes insists that most investors react less to greed and more to hope. Nowhere is that more visible than in both primary and second home investment.
“Fear induces an investor to focus on events that are especially unfavorable, while hope induces him or her to focus on events that are favorable,” writes Hersh Shefrin in discussing the theories of Dr. Lopes. The fact that a homeowner will insist that his or her home is still worth its full value, despite a decline in neighborhood prices or even the overall economy, isn’t based in greed. But is a hope as Dr. Lopes knows well. Only if and when it becomes absolutely necessary to sell a home in a down market will a homeowner finally, reluctantly, accept the fact that the value of his or her home is less than it was before.
Second Homes as Rentals
Homes held strictly for rental, and not for personal use, are diverse and defy categorizing. A rental home can be a cooperative in a big city, a duplex in an aging neighborhood, a bungalow in a suburb, farmland in a rural area, or a condo unit in a coast resort.
The owners of these properties can live anywhere. Although many investors prefer to own property they can access easily, many people who relocate choose to rent the home they are leaving rather than sell it. With enough cash flow, price appreciation and/or property management, this can be a good investment decision.
Rental property investing is a small business that can help owners gain financial independence. If you choose to hold or purchase one or more investment homes to rent, you are your own boss. You can set your own goals, make your own decisions, and work at your own pace. The return from a rented home can be in cash flow or in price appreciation or both. As long as the home is cared for and your carrying and maintenance costs are covered, you have little to worry about, except a steep decline in the housing market just when you want to sell.
About the Author
Lois A. Vitt is a housing expert and financial sociologist, and is the author of “10 Secrets to Successful Home Buying and Selling”, the first book to demystify the psychological forces behind our housing decisions. To learn more about Lois and this book, visit www.RealtyStudies.com.