Real Estate is an Inefficient Market

… real estate is an inefficient market, in which prices are set solely by the meeting of the minds of the seller and the buyer; the two people, or entities, who make decisions based solely by their respective circumstances, and having very little if anything to do with the market at large.  This makes value in real estate very much a moving target.  Often enough, that property you’ve just bought for $100,000 could actually be worth $130,000, in which case you did good; it could also be worth $75,000, in which case you paid too much.

The Efficient Market Hypothesis is a theory that the price of a security at any given time reflects all of the available pertinent information.  That is to say that at the moment you purchase the asset, the price that you pay reflects the true value of that asset.  This theory has been around since around the 1960es , and while there may be appropriate application for this theory relative to paper assets such as stocks and bonds, it is completely inapplicable relative to real estate.

In fact, real estate is an inefficient market, in which prices are set solely by the meeting of the minds of the seller and the buyer; the two people, or entities, who make decisions based solely by their respective circumstances, and having very little if anything to do with the market at large.  This makes value in real estate very much a moving target.  Often enough, that property you’ve just bought for $100,000 could actually be worth $130,000, in which case you did good; it could also be worth $75,000, in which case you paid too much.

More importantly, the inefficiency of the real estate market allows you, the owner / investor to do things that would increase the value of real estate through management.  Thus, often enough a skilled investor will negotiate a purchase price of $75,000 on a property that is reasonable worth $100,000.  And within a short time and with $5,000 worth of management expense, this property can be worth $130,000, thus creating equity position for this investor of $50,000.

End Value – Purchase Price – Management Expense = Equity Position

Thus: $130,000 – $75,000 – $5,000 = _$50,000

Another way of looking at this scenario is that the total investment of $80,000 which produced $50,000 of equity for the investor is a 62% return.  And if you are wondering, this type of a transaction is nothing out of ordinary.  These types of returns are quite pedestrian in the world of real estate specifically because it is an inefficient market.

For example, several years ago I bought a small 2-bedroom house with an unfinished attic for $24,000.  I spent $20,000 on the remodel which included converting the attic into a third bedroom.  Upon completion of the remodel, which took just over one month, the house was appraised by the bank at $70,000.  Thus my total investment of $44,000 produced equity in the amount of $26,000, which is 59%.

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