If you are investing in San Diego real estate, or any real estate for that matter, there is a single idea you should be using to evaluate every property of interest. Outside of Wall Street, however, it’s rarely discussed and you may be missing out on this infinitely useful and fundamental concept in investing. You see, real estate investing may be unique in a number of ways, but the ultimate objective differs little from most other forms of investing. Whether your goal is cash flow, equity appreciation, tax relief or wealth protection: in the final analysis you are looking for an arbitrage.
The market, if it’s open and transparent, balances pricing between competing interests. On one side there is a seller. The seller believes there is an acceptable profit (or loss of future profit) for a reduction of risk. On the other side there is a buyer. The buyer believes there is an acceptable potential for profit (or future profit) relevant to an increase of risk. These levels of acceptable risk and commensurate reward encompasses many variables and are generally beyond the scope of one article. What’s important is this: the ratio of risk and reward varies from person to person! It is this difference in opinion, as the saying goes, that makes a horse race. It is also where we find opportunities to create a profitable investment. (Notice I say “a profitable investment” rather than just profit. That’s because I am referring here to an outcome matching your goals. Flipping a house may create a literal profit, but so can taking a monthly loss against gains for tax purposes. Profit is generally an increase in immediate cash, whereas a profitable investment may be rewarding in other ways.) You do not have to understand all of the variables (although we do and it certainly makes a difference), the investor’s primary concern is a comparative knowledge of their sum total. That is to say: a knowledge of when the risk and reward are out of balance. This creates an arbitrage opportunity.
(Note: this is not an arbitrage in the true sense of the word. A true arbitrage takes place almost simultaneously and involves no market exposure. This is done in electronic markets that are extremely liquid… neither of which applies to real estate investing. Going forward, I am using arbitrage in a simpler context: the opportunity to create a profitable investment by recognizing a discrepenacy in the marketplace.)
When pricing gets out of balance, the very act of arbitrage will right it again. Our job then, is to find – or create – these opportunities. There are three areas you can arbitrage in real estate: knowledge, timing and finances. If any one of these creates an advantage in pricing that the market hasn’t (or can’t) balance, you have found a profitable investment. Let’s take a look at an example for each of these and see how they interact.
Example 1 – Knowledge Arbitrage
There is a home for sale and it has a cracked slab. This has sent most buyers running in the opposite direction and for good reason: if you don’t know how to properly fix a cracked slab your expense risk is completely unacceptable. Plus, this lack of knowledge prevents you from properly pricing the property which means you cannot write an informed Offer to Purchase. You should pass. The seller, Sliding-Away Sally, knows all of this is happening because she has been advised by her very informed and helpful listing agent. She has therefore priced the home according to her belief in an acceptable gain (or loss of future profit) against a reduction of the risk and potential for future loss associated with a cracked slab house. Now, along come our hero: Arbitrage Andy, and he knows quite a bit about cracked slabs. He knows roughly what it will cost to fix based on his own inspection and he has access to people who will do the work. Arbitrage Andy looks at the work involved on Sliding-Away Sally’s place and sees that there isn’t nearly the work everyone thinks there is. Due to his superior knowledge, Arbitrage Andy is able to buy this house for much less than it’s worth, perform the work and reap the reward of a knowledge arbitrage.
Example 2 – Timing Arbitrage
A home owned by Sloppy Sam is not for sale… yet. The listing agent doesn’t want to put it on the market in its current condition. It is such a mess that neither Sloppy Sam nor the listing agent have a good idea what it might sell for once it is on the market, but they’ve priced it according to their belief in an acceptable gain (or loss of future profit) against a reduction in the risk that comes with owning this mess. Along comes Arbitrage Annie and she sees the agent leaving the house (his car is plastered with advertising) so she stops him and asks if the place is going to be for sale. She discovers that it’s for sale now, but no one knows about it yet. Arbitrage Annie asks to go inside, sees that the “mess” is purely cosmetic asks what they want for the “dump.” A little embarrassed, the listing agent throws out the low number he has previously discussed with Sloppy Sam. Arbitrage Annie looks around disappointed, takes another 5% off and says that’s the best she can do. The seller takes the offer and Arbitrage Annie, thanks to being ahead of the competition and quick to act, will enjoy a very nice profit for her timing arbitrage.
Example 3 – Financial Arbitrage
Here’s a relatively simple example: the Not-so-Nice Niece and Nephew of Dead Donald want his house sold so they can pay off bills with their share of the profits. They have two offers in already when Arbitrage Alex talks to the listing agent and discovers the seller’s needs. He offers less than the other offers and gets accepted because he can pay all cash and close in seven days. The estate of Dead Donald believe the reduction in profit is balanced by the short escrow and the lack of exposure to the lending world created by the all cash offer. Arbitrage Alex gets a great deal on an investment because he had liquid cash and could act quickly on a financial arbitrage.
There are many ways these three opportunities may interact. I have personally done deals involving all three of the scenarios presented. In the end, you will find your profitable investments are those in which you were able to leverage your ability to recognize and act on a knowledge, timing and/or financial arbitrage.
Filed under: INVESTORS , Arbitrage, finance, knowledge, profitable investment, Real Estate Investing 101, timing
