The Difference Between Speculation and Proven Value

Last week I looked at an investment property in Nashville, TN that is about as cheap as it gets right now, priced at $40,000. I had previously driven by the property and given it a bit of thought, but I needed to see the inside before I knew what investment options were in play. After meeting the owners and viewing the inside, it turns out that there are a few different strategies for this property. But it seems the most profitable options are all reliant on a higher future value. Guessing that the value will rise is speculation, where the expected profit comes from the future value, not the present value. Regardless of if the guessing turns out to be correct or not, the investor is still taking a leap of faith.

I don’t buy on speculation, but typically only buy properties at a discounted price of their current market value. Of course I try to buy in areas where there will be significant appreciation, but I’m not basing my whole purchase on a future value that may never come. I choose to buy proven value, where my purchase price is 65-70% of market value. But with such a cheap price of $40k, and new construction infill creeping closer and closer to this location, should I take a gamble? Should I bet on future value and speculate?

It was cold outside on the day that I looked at the $40k cinderblock house, and it wasn’t much warmer inside the dwelling. It was built in 1947 and is just over 900 square feet. But it is in very poor condition. The house is currently rented to a borderline hoarder who uses the two bedrooms for storage and has a mattress in the living room. That arrangement may be done for economical purposes, as he was heating the house with a space heater. By closing off the bedrooms and kitchen (with a heavy blanket hung over the doorway), he created a smaller space to try to heat. The rough living conditions were reflected in the minimal rental rate of $375 a month, which is the cheapest rent I have ever heard of for a single family house in Nashville. But after looking at the inside, I can’t say the rent is too low.

My first strategy for buying this house would have been to do a light renovation (paint everything, new flooring, light fixtures, faucets, etc.) and raise the rents to a reasonable $750-850 a month. After seeing its present condition, which was considerably worse than I was hoping for, I didn’t think that the house was worth sinking a few thousand dollars into. Not when the lot value could possibly exceed the value of the house.

The second option for this property was to simply tear down the house (which was hanging onto habitability status by a thread) and build a new one. The zoning of the property is RS5, which means it is classified for one single family home per 5,000 square foot lot. With dimensions of 50? x 125?, this lot could only hold one house according to the current zoning. The sellers of the property, who are investors themselves, noted that the property could potentially be rezoned to allow two houses on the site. For a $1,400 application fee with the city, it definitely seems like it is worth a shot, but there are no guarantees. Rezoning is a lengthy process (3-5 months if there are no complications) where the applicant is required to mail notifications to all nearby neighbors, meet with the Metro Council representative, get a Planning Commission recommendation, and finally have the mayor sign the bill. If it is rezoned to allow two single family structures, the $40k price tag is much more appealing. $20k per building pad is difficult to find in Nashville’s inner-ring neighborhoods, and it greatly increases the chances for profit potential to build two homes instead of one. In this location, two $199,000 smaller houses would be easier to sell than a bigger one priced at $319,000.

I briefly considered this option of new construction, but I don’t like the limited profit margins of only one house, and I don’t want the hassle of trying to rezone for two when it could be rejected anyway. Ultimately, I didn’t want the risk of building on a street where new construction is unproven. Sure, dozens of new homes in The Nations neighborhood are regularly selling over $300,000 less than a mile away. But the immediate vicinity of the $40k house has no established comparable sales. It would be very pioneering to build new at that spot.

The approach that I considered the most was to buy this house and keep renting it for a few more years as long as the tenant would stay. This holding period would be the optimal time to try to rezone the property. As the surrounding renovation and new construction projects continue to get closer in proximity, the property value would rise accordingly. At some point, the comps would be close enough to justify building the new house or houses. When that point is reached, I could sell the property to another investor/builder, or hire a builder myself.

The problem with that plan is that it is all based on future expectations and hopefulness. Yes it could work out perfectly as I described above, but what if interest rates suddenly spike or the national economy halts into a recession? If the progressing redevelopment of nearby neighborhoods stalls out and the value doesn’t appreciate as projected, what becomes of this property? Would it be destined to be a $375 a month rental?

Ultimately I passed on this property because I don’t want to tie up $40,000 on a property that depends on future conditions that I can’t control. Clearly, all real estate is subject to a range of factors that can’t be controlled by an individual. I would rather put that money toward a deal that is a discounted proven value. All of the properties I have purchased were in locations that I was content with in their present state. I wasn’t gambling on what the neighborhoods would become. I wasn’t speculating. Nor do I intend to now.