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Real estate investing can be risky

Dear Dr. Don,
My friend is telling me that he can take out a home equity loan on his house and use that as a down payment on another house that will be built. Then, once the new house is built, he can sell it at a higher price. Can you actually do this with an equity loan in order to build wealth? In theory this sounds good. Thanks.
-- Tony Turnover


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Dear Tony,
You can take out a home equity loan and use the proceeds as a down payment on another home. Planning to sell the second home soon after it is built is called "flipping." Your ability to flip a property at a profit requires the property to appreciate enough in value to more than cover your costs. It also can depend on how the sales agreement is written.

Builders and lenders would prefer to sell to residential customers rather than investors or speculators because people looking to flip properties are competing against the developer for sales. And the mortgage investor doesn't like seeing a 30-year mortgage paid off so soon after closing.

To that end, builders are trying to stymie flippers by writing anti-speculation clauses into sales agreements. A typical anti-speculation clause in a sales agreement will penalize the speculator if the property is resold within a year. The clause, for example, may provide the builder with a pre-emptive right to buy back a home at the original sales price within a year of purchase.

Can you build wealth by speculating in real estate? Sure. You just have to find someone who will pay more for the property than what you have invested plus your costs. My concern is that the run-up in real estate prices over the past few years was fueled mainly by low interest rates, and to count on that trend continuing with mortgage rates poised to move higher isn't all that realistic.

Speculating on the trend in real estate prices is risky because real estate can be an illiquid asset. Getting out in time requires you to liquidate your holdings before the trend ends. Will you know when the music is about to stop?

Bankrate.com's corrections policy
-- Posted: June 9, 2005
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