The Myth of the Real Estate Pioneer

Speculating in unknown or unsafe neighborhoods is a risky game.

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 Everyone's heard a story about a friend of a friend who bought a house in a neighborhood just before the neighborhood took off. The person paid a small amount for a home—say $50,000—and saw a huge payoff, usually something in the range of a five-fold return on the original investment.

Call these people real estate pioneers: They venture into unknown or unsafe areas after getting a tip that the market in that area is about to get hot. They're ahead of the curve, beat the rush to move to the new, hip part of town, and save tens of thousands of dollars in the process.

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There's only one problem with the legend of the real estate pioneer: It's entirely untrue. According to experts, timing when to purchase a home in a questionable neighborhood is a dark art. When first-time homeowners get into this kind of speculative game, they are flirting with financial ruin.

"If you're going to be doing this kind of investment, you ought to be doing it with speculative funds," says Roger Staiger, an adjunct faculty member at the Johns Hopkins Carey Business School. "It's a strategy best used for people who are quasi-wealthy. It is not a strategy I would recommend for the average Joe."

Infinite downside. Staiger uses a comparison with investments in stocks and bonds to illustrate just how costly a bad real-estate bet can be. If an investor puts $10,000 into the stock market, the most the investor can lose is $10,000. The same can be said for the bond market—a $10,000 investment can lead to a loss no worse than $10,000.

Homeowners are responsible for mortgage payments, housing upkeep, and property taxes, among other expenses like utilities. So if the house can't be sold, the potential downside for a $10,000 housing investment is infinite. "You can also get a neighborhood that just languishes forever," Staiger says.

The unpredictability of the employment market also adds to uncertainty about the future of a neighborhood, Staiger says. Often, areas become hot because of the availability of work nearby. But it's never certain that these jobs will stay in the area forever. And if the jobs leave, the real estate market will suffer.

In the past, "there wasn't a whole lot of movement in labor. Now labor is mobile. You're constantly moving. The only thing certain about real estate is the bill," Staiger says.

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Data from the National Association of Realtors (NAR) supports this. According to a recent NAR survey, beating a market does not rank high on the reasons people move. "The biggest factors influencing choice of location were quality of the neighborhood, cited by 67 percent of buyers, convenience to jobs, 49 percent, overall affordability of homes, 45 percent, and convenience to family and friends, 39 percent," says Walter Molony, a spokesman for NAR. "Other factors with relatively high responses include neighborhood design, 32 percent, convenience to shopping, 28 percent, quality of the school district, 27 percent, convenience to schools, 22 percent, and convenience to entertainment or leisure activities, 21 percent."

Inside info needed. According to Robert Simon, a professor of urban studies at the Levine College of Urban Affairs at Cleveland State University, timing a real-estate market requires extensive local knowledge of an area.

"There are micro-hotspots that require local knowledge. Zoning for new projects, public investment for highway projects—these are both things that have a positive affect on value," Simon says.

Simon adds that the large number of foreclosed homes on the market make it even more difficult to predict future housing prices. Until the market is flushed of these homes, unpredictability will reign.

"There's insidious linking between the markets," Simon says, referring to the foreclosed housing market and the traditional housing market. "All prices are going to get dragged down."

[See 5 Smart Ways to Buy a Foreclosure.]

A game for the rich. Both Staiger and Simon say real-estate speculation should be left to the rich. "Your primary housing vehicle should not be considered an investment—it should be a consumptive asset," Staiger says. "You shouldn't be betting with your family's security, which is what a house really should be. It should be a savings vehicle that costs you less every year."