Why do so many people buy overpriced real estate?

Image by Oliver Putz from Pixabay

Real estate investments have become very popular in recent years. A real estate investment can be very lucrative, but it also carries risks. Especially if you buy a property that is overpriced by current standards.

But why are there then so many people that are willing to buy properties that are completely overpriced?

I think the main reason for this is the current fiscal conditions: we currently have a lot of money in the markets because of the loose central bank fiscal policies. And let’s face it: that money has to go somewhere! And so it goes into different asset classes. Vintage cars, stocks, old whiskeys, or real estate.

Investors flock to real assets because they see how much their money is being devalued by inflation.

According to the German Federal Statistics Office, the inflation rate in Germany rose to 7.4 percent in April! The last time there was such a high inflation rate was over 40 years ago, in 1981.

With such inflation rates, even if a property yields a poor return of only 2%, many people think "what are the alternatives?". Leaving money in the bank at such an inflation rate is as good as burning money.

But what does it mean to you when you buy an overpriced property?

What does an overpriced property mean for financing?

In the case of an overpriced property, the market value and purchase price are far apart. And this gets very relevant for you when it comes to financing your investment. Keep in mind, the bank does only marginally care for the purchase price you have struck with the seller.

When it comes to financing your investment, the bank in fact looks at the value of the property and calculates the maximum loan on this basis.

Let’s make an example: If a property is worth €400,000, but you buy it for €550,000, you may have to pay the difference out of your own pocket. If you as an investor buy an overpriced property, you must bring far more equity into the deal than with a reasonable purchase price.

Note: if you want to know more about the financing risks when buying an overpriced house, also have a look at the article "What you should know about the risks of real estate investing before doing your first investment" on this blog

Hoping for a positive performance

When buying an overprices property, many investors therefore rely on an increase in the value of their investments due to the low returns on their real estate investment.

Yes, this has worked great in recent years. Between 2010 and 2020, real estate prices in Germany have risen by an average of 65%! So as long as prices rise, all is fine…

How do I earn money with real estate?

Real estate can be a great way to build wealth.

But in order to make money from real estate -- without speculation -- your monthly expenses (interest, repayment, maintenance and administrative costs) must be lower than your rental income. If you achieve this, you have a positive cash flow, your tenant pays off the apartment and your investment is self-sustaining.

But for this to work, you need to buy real estate at reasonable prices. In the best case, your property appreciates in value, but even if not, your investment needs to be self-sustaining.

If you buy a property that is too expensive, you end up with a negative monthly cash flow and must bring money out of your own pocket into the investment every month. Your investment is no longer self-sustaining.

If you are lucky, prices will continue to rise, and you will be able to sell your property again in a few years at a profit.

But that exactly is the point where I think your investment turns into a speculation. Like everyone who buys overpriced real estate today, you speculate that the inflation will continue to raise the value of real estate. A speculation that can work, but does not have to.

 

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