NEW YORK (CNN/Money) -
I'm thinking of buying the half-acre lot next to my new home. I think it would be a good investment because the price seems reasonable and I know that some nice large homes are being built in my neighborhood. But I wonder: Is there any way this could this be a bad choice?
-- Sharon, Statesville, North Carolina
First, let me congratulate you for asking yourself a question that too many people fail to ask before they invest: What could go wrong?
We always think about the upside when making investments -- what size returns we might get, how much money we'll have, what we might do with the windfall profits. But we tend to gloss over or outright ignore the downside. Maybe we're just inherently optimistic, or we get caught up in the excitement of the chase of high returns.
And in a case like this, where the investment opportunity lies right next door, we naturally feel more comfortable about investing. So maybe we don't even foresee much of a downside. But I can tell you that anyone who invests for a living -- at least anyone good at it -- always considers the potential pain as well as the gain.
Looking at the down sides
So with that thought in mind, let's consider for a moment the things that could go wrong.
Since we're dealing with land whose value hinges on the ability to develop it, let's start with regulatory matters. Are you positive you can actually build on the lot? Is it large enough, does it have enough road frontage, does it allow for adequate "setbacks" from the street or from your house or a neighbor's?
Are there any restrictions on tapping into the municipal sewer system or water supply or, if you're not using municipal facilities, any problems digging a well or putting in a septic system? How about restrictions on the type of house or the size of house you can build?
Most communities have a local planning board or other office that can give you the ground rules that apply to development in your area. You'll definitely want to know what those rules are before you buy the lot. Even if there are restrictions, you may be able to get a variance.
If you're counting on that, you might first want to gauge whether you're likely to meet resistance from homeowners or neighborhood groups that might oppose more homes going up in your area. Even if you don't intend to build on the lot yourself, you still need to address these issues because you can be sure any informed buyer is going to check out this stuff.
Ultimately, the market value of the lot hinges on these issues, so you don't want to run into any unpleasant surprises after buying that limit the property's resale value.
Gauge the market
You'll also want to do a bit of research to gauge the demand for houses in your area. Has it been brisk enough to drive prices up at a decent pace -- or have prices been stagnant?
And while you're at it, check out the supply of houses. You mention that some new houses have gone up recently. Have they sold or are they still on the market? Any others in the planning stage? And how about sales of existing homes -- have they been moving at decent pace or are they languishing on the market for months and months?
A talk with a couple of local real estate agents and a look at such stats as the average number of days a house is listed before selling and how close the house sells to the listed price should give you a pretty good idea of the overall vibrancy of the housing market in your area.
Once you've got a sense of that, keep in mind that you've got to think ahead a bit. If the economy in your area is slowing, that could soften demand for houses, which in turn could mean a lower resale price for the lot. You could end up being forced to hold onto this lot longer than you think.
Is this the best place to put your money?
Finally, I think you ought to consider whether this is the best use of your money. Are there other investments that might deliver a comparable return without the hassle?
Remember, you already have money tied up in a real estate investment in your area: your home. Do you really need to devote more resources to the same asset class in the same city in the same neighborhood on the same street? You'll be flouting the cardinal investing tenet of diversification.
If you have plenty of plenty of other investments -- a nice fat 401(k) you're funding to the max, plus stock and bond mutual funds you own in other accounts -- then maybe picking up more real estate might make sense. But I'd be wary of taking on more of an asset class that already probably represents a good portion of my net worth if I weren't well on my way to building a portfolio of financial assets that will support me in retirement.
You may feel differently, of course. I know that lots of people prefer real estate to financial assets. They like the fact that it's tangible, they can see it. Just be aware of the risks of such a strategy.
One last thing. The fact that this lot happens to be right next door may give you the feeling that this investment is much safer than others and that you have much more control over it than other investments. But that sense of control is largely illusory.
Sure, you can develop the lot and build a nice house and market the house like a pro. But, ultimately, you don't control the price you will get or the return you will earn on this deal any more than you control the return you get on a mutual fund or stock.
The return you earn hinges mostly on the economics of your area and how wage and population growth and development patterns are reflected in the supply and demand for homes in your area.
So I recommend you think of yourself not as a homeowner looking at the lot next door but as a developer coming in from outside of town scouting out potential investments. If you're not willing to do the research that such a developer would do, then I don't think this is the investment for you.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "We're Not in Kansas Anymore: Strategies for Retiring Rich in a Totally Changed World."