This article explains why speculators — as a distinct type of real estate purchaser — profit disproportionately during a recovery, and what the next speculator increase means for California’s housing market.

Why the spectacle?

A real estate speculator slips into the real estate market, sandwiching themselves between the seller and the end user homebuyer — usually a buyer-occupant or long-term buy- to-let investor.

Their goal is to purchase the home at a discount (their belief) and sell soon after acquiring it for a juicy profit when prices inflate (their expectation). Their gamble is to buy now on the belief prices will increase by 50% or more in two or three years. All this is a bet a profit can be had, after the costs of:

  • acquisition;
  • carrying costs; and
  • selling.

In a normal, healthy housing market, speculator transactions make up roughly 20% of all home sales. However, during the recovery from the last recession, in mid-2013, the number inflated to 35%, decreasing to roughly 25% in 2014 and returning to normal levels of around 20% by 2016 as the economic recovery began to solidify.

Why do speculator transactions rise during times of economic recovery? To answer that, a quick history lesson on speculation is helpful.

Speculation through the ages

The history of real estate speculation in the U.S. can be traced all the way back to 18th century New England. The price of land was rising fast and investors flocked to gamble their fortunes on ever higher prices. The price bubble quickly burst (as bubbles by definition tend to do), leaving those who confidently gambled the most and got in last with nothing. The cycle of boom and bust (and resultant speculation occurring in between) has repeated itself time and again since then.

Speculation has always played a natural role in housing markets, and for good reason. When home sales volume sputters during times of economic chaos, speculators provide the much-needed support of cash providing liquidity in the market by entering as prices drop for lack of consumer will to acquire. But the magnitude of speculation has a habit of increasing to the point of instability, which was the dynamic felt in California between 2013 and 2014.

The role of speculation during the Millennium Boom

The Millennium Boom was caused by a number of contributing factors. However, it was all triggered by Wall Street Bankers and mortgage default

levels mortgage-backed bond (MBB) investors never thought would come to be (as erroneously portrayed by Wall Street Bond Rating Agencies). Everyone wanted to believe that homes were, well, golden.

Then, someone on Wall Street became disenchanted with day trading and decided to put some money into MBBs. Soon enough, Wall Street types all flocked in the same direction, funneling money into mortgages, making home financing readily and unquestionably available to all. This rush became a financial accelerator, making it easy for anyone to get a home mortgage at ever greater home prices. All they needed to do was step into a bank and sign on the dotted line, with a real estate agent or builder in tow.

Government deregulation of mortgage products enabled the proliferation of no doc or liar loans with payments hybridized and structured so everyone qualified — at the time of recording. Meanwhile, the Federal Reserve (the Fed) had allowed the economy to grow out of control by pumping money into the economy in late 2001 before the recession had time to work its magic to cool the economic engines.

At the same time, Congress was fast at work deregulating mortgage bankers while government administrative agencies were defanging enforcement staff.

Builders were then able to sell new homes to those hordes of families who had no down payment and could not sustain payments on the mortgages they took out. Negative amortization had become a positive. RIPOFF mortgages of the day comprised “Reverse Interest & Principal for Option Fast Foreclosure.” Thrown in was the ZAP mortgage offering “Zero Ability to Pay” at six months as the qualifying teaser rate adjusted into oblivion. Great fun, until 2007 put end to it

Prior to 2008, it was common practice for builders to actually provide the minimum down payment required by the Federal Housing Administration (FHA) for an FHA-insured mortgage, and eventually conventional mortgages. These mortgages were typically called Nehemiah loans, all part of HUD deregulation from the late 1990s forced into existence by litigious home builders and political influence. As a plus, 80/20 piggyback financing came into vogue, allowing for no down payments.

Sky high optimism

Come 2006, buyer optimism was without a ceiling, and home prices rose higher. In this year — just as prices peaked and began their steep, three-year descent — 81% of surveyed consumers in Alameda County and 75% in Orange County said it was a good time to buy. They erroneously believed home prices were likely to increase, according to the Brookings Institution. It was a case of expectations of ever-increasing resale volume and prices based solely on recent experiences of others, which are only fulfilled when no one is able to buy.

Consumer expectations were improperly based on the price movement of the moment (which was up). Like most, and at their peril, they ignored all other signs (such as falling home sales volume and the yield spread on bond rates) which unmistakably pointed to decreasing home prices by early 2006, with worse to follow.

And so, homebuyers and lenders continued to pour wealth into the failing housing market, not knowing that they would be the last in a long line of speculators to be holding the hot potato. A monumental lack of understanding about real estate itself both generates profits for the lucky speculators — and losses for those less lucky ones.

Related article:

Zillow Offers’ failure is a warning to today’s speculators


The role of speculation in 2023-2025

In 2023, an undeclared recession has already begun to settle over the economy — especially weighing on the housing market, with sales volume and prices spiraling in 2022. In acknowledgement, the economic recession is likely to officially arrive mid-2023.

To forecast speculator activity in the years following the 2023 recession, it’s useful to glance back at their presence in the recovery from the 2008 recession.

They stood by for five years while prices descended. Then, speculators gathered en masse around low-tier California homes by mid-2012, expecting to finally take profits from the recovering real estate market. Some came to the market confused, thinking hard appreciable assets — even gold — at whatever prices were better to hold than the U.S. dollar. They misunderstood the relationship between the Fed pumping money into the banking system during cost-free periods of zero lower bound interest rates, an over-indebted population in need of deleveraging by foreclosure, corporations flush with cash with no need to borrow and no foreseeable consumer inflation for a decade or more.

With this general ignorance and misunderstanding of the economy, the speculator presence picked up significantly in mid-2012. At that time, the red-herring issue of low housing inventory was said by media pundits to be pushing home prices higher. Perceiving a long-term price shift in the making, speculators began to flood in, month after month, increasing competition to buy homes freshly listed for sale.

They flocked from home to home, all submitting offers the instant each came up for sale. Their bet was to make money on market momentum pricing alone. End user buyers — the few out there — stood little chance in competing against novice but cash-heavy speculators intent on buying everything in sight. Property disclosures became meaningless, corrupting sellers’ agents in the process of furious acquisitions.

Return to normalcy

Speculators are notably diminished in 2023. They are discouraged by several influential market factors, in particular, by the present state of home prices.

California home prices crested in May 2022 and have since plummeted to 7% below the peak for low-tier prices and 10% below the peak for mid- and high-tier prices. Meanwhile, end user homebuyers are deterred by rising mortgage interest rates and a shaky economy, allowing more homes to linger on the market.

Investors, even impulsive ones, have a hard time justifying purchasing when inventory is rising and prices are falling. End user homebuyers get the math of dropping prices and put a stop to making offers.

Speculators will return once it’s clear that prices are juicy with profits.  Soon, prices will find a bottom. firsttuesday forecasts prices will bottom in 2025.

Then, prices will gradually rise during the recession’s recovery, helped along by a return of real estate speculators and long-term buy-to-let investors. The housing market will get a jumpstart before buyer-occupants feel confident enough to return in large numbers.

Related article:

Agents and brokers: recession-proof your life

What motivates speculators to gamble?

Homebuyers of all types generally purchase homes for five sound economic reasons. These are, in order of importance:

  • annual property income (in the form of rent, paid with money by a tenant or paid implicitly by the owner occupant);
  • equity build-up as principal on mortgages is paid off (as savings by installments paying for the property over 30 years);
  • consumer inflation hedge (as asset value increases to offset the dollar decline in purchasing power);
  • appreciation due to location (it attracts more people or personal incomes locally rise faster than consumer inflation — demographics); and
  • the tax benefits of reduced taxable income and tax-free profits due to homeownership (effective primarily for the wealthier, older population). [See RPI e-book: Tax Benefits of Ownership]

Speculators practice these fundamentals in the reverse order of importance. Their most significant motivation is the potential tax benefits of a purchase. Then, appreciation generated by recovery behavior.

Speculators are essentially day traders who think they’ve found an easy, tax-friendly investment. They take advantage of the federal government’s homeownership incentive — long-term capital gains tax — by owning a capital asset for at least 12 months before selling. Thus, three years is the typical plan to warehouse title before implementing the initial intent to dispose of it by resale.

But not so fast — do speculators really qualify for the capital gains tax limit?

No, not really. In order to qualify, the property sold cannot be purchased with the intent to sell in the normal course of the speculator’s business. Said more clearly, the speculator cannot be a dealer of property, in which the homes collected and sold are considered inventory — property held primarily for resale. [Little v. Commissioner of Internal Revenue (1997) 294 CA9th 661]

So how do speculators get away with it? The answer is that many will not get away with it. When the Internal Revenue Service (IRS) audits these speculators, they will be asked to pay up.

Will the gamblers of the 2024-2025 period betting on a flip cash out at a profit? Or take a loss?

For the most part as in the past, they will not experience the returns they want, before or after taxes.  The first in will likely profit; those later, less likely, until all further buyers will lose.

Can speculation really drive a recovery?

Real estate speculators assist a struggling housing market during recessions by providing cash — liquidity — bolstering sales volume when few users are willing to buy. But the magnitude of speculation which occurred in the 2013 recovery period was damaging, as liquidity needed by real estate owned (REO) property lenders and builders during a recession — the inability of a seller to find a buyer — was no longer the problem.

For developing headwinds adversely affecting sellers going into the next few years, think of:

  • the shadow inventory of future forced sales, delayed first by the foreclosure moratoriums of 2020-2021, now rising with the number of underwater homeowners;
  • speculators’ combative acquisitions once prices have bottomed in 2025;
  • the historical real estate mean price trendline as a magnet to which California real estate prices eventually return;
  • the certain acceleration of residential construction starts as local NIMBY-controlled politicians are forced by the state to open up zoning and building to house the growing population; and
  • the ongoing increase in mortgage rates and enforcement of mortgage lending fundamentals by federal consumer protection agencies.

The illusion of recovery

For casual observers of the real estate marketplace, speculator acquisition activity creates the illusion of a quickly recovering housing market. But by their removal of homes from the grasp of end users, speculators actually prolong the housing recovery.  Worse, they corrupt the conduct of real estate agents willing to participate in the process.

Can anything be done to suppress speculator activity to level out price movement (without unnecessarily restricting sales volume) and provide priority to better position buyer occupants to acquire a home?

Yes. Institutional lenders need to implement underwriting guidelines that restrict loan-to-value (LTV) ratios by lowering them for speculators more than for buyer-occupants (and yes, speculators have avoided this by paying cash). The FHA has guidelines against flipping in an effective effort to modify price increases, though these were temporarily suspended in 2010-2014.

Other suggested regulations over speculator activity during recovery periods (not recessions) include historical solutions, such as:

  • a down payment requirement of 30% for reason that speculators, with less of a vested interest in a property, are way more likely to default than an owner-occupant;
  • a restriction against purchase-assist financing of a flip within 360 days of acquisition by a non-occupant buyer;
  • an interest rate surcharge — a tax — on non-occupant buyers seeking financing (much like the mortgage insurance tacked on to home mortgages for more than 80% LTV for reason of higher risk and default rates among speculators); or
  • an income tax rate surcharge on profits for a class of absentee homeowners who do not retain ownership and sell more than one home in four years.

Organic recovery

So, what will truly support an organic real estate recovery? It all comes back to jobs held by end users of real estate, and the wages they received. End users need an income before lenders will fund home or commercial property purchases.

Jobs lost during the 2020 recession were just recovered in October 2022. However, the 2022 monthly pace of additional jobs subsided each month, with a steep drop anticipated in January 2023.

Do not depend on speculators to fuel your real estate sales in 2023 or even 2024. Look first at the local jobs numbers as they are released, and they will vary considerably depending on where in the state you are located. As job numbers begin to climb, a pickup in sales volume will follow. Conversely, speculators come and go based on market momentum, and generally rising interest rates will hold back the market from overheating in the years following 2023.

Related video:

The recession is imminent — for real estate, more of 2022; Monthly Statistical Update (January 2023)