Warren Buffett is the gold standard in the investing world. He has outpaced his contemporaries with eye popping returns and a simple approach. So when I started investing I naturally sought to understand and emulate the Warren Buffett investment philosophy.
I devoured everything that I could find on his strategy, process, and principles. He is famous for an annual letter he wrote to shareholders. His annual letters outline his investment approach, key wins, mistakes, and his evolving worldview. So I read every shareholder letter since the 1960s. I was a fan, but there was just one problem.
I Hate Stocks
Warren Buffett built his early career by buying publicly traded stock that anyone could buy. He spent countless hours reading annual reports and researching industry publications. I liked evaluating companies, but I hated the lack of control and visibility that comes with being just one of a million shareholders in a large company. On top of that the stock market is fairly efficient most of the time. It is also dominated by enormous investors with deep pockets and more access to management than I could reasonably expect. I had a great strategy, but limited information and no defined competitive advantage.
Instead I turned to real estate in 2007. What I found was the perfect market to execute Buffett’s investment philosophy. An oversupply of properties, limited buyers, and plenty of motivated sellers. A value investor’s dream. I have spent the past decade executing the Buffett playbook and refining his investment philosophy to fit real estate investing. I’ve boiled it all down to five key principles for consistently successful real estate investing.
Margin of Safety
“Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.” – Warren Buffett
— Jean Tabor (@Jean_Tabor) October 21, 2016
So I’m not naïve. Some small percentage of readers won’t make it through the whole article. It’s sad, but true. With those folks in mind, I decided to start with the most important rule for successful real estate investing. Never Lose Money!
Sounds great, but how the heck do you do that? For that I direct you not to a rule, but the first principle…Margin of Safety. With any successful investment you need a conservative, reliable, and defensible margin of safety.
Simply put, a margin of safety is the extra cushion that you build into your analysis of any potential real estate purchase. This covers all those what-ifs
What Happens When…
- Rehab costs exceed your contractor’s estimates?
- The market is bad when you need to sell?
- Your new tenant loses her job?
- And the myriad of other things that can go wrong with real estate investing
If you are looking to flip a home, the standard margin of safety is a 30% cushion between the expected After-Repair Sales Price and the Total Expenses (Purchase Price + Rehab + Closing/Holding Costs).
The margin of safety required for buy-and-hold rental property will vary a bit more by the neighborhood that you are investing in. A new, affordable home in a desirable neighborhood likely needs a smaller cushion than an older home in a lower-income area. As a general rule, the riskier the investment, the bigger your margin of safety should be.
Here are a few of the factors that I consider when evaluating the appropriate margin of safety
- Worst case vacancy
- Potential eviction costs
- Unexpected Repairs
For my properties in Detroit, I conservatively estimate all my expenses will eat up 6-8 months of annual rent. That leaves a 4-6 month margin of safety. In good years that’s my profit. In bad years it’s my safety net.
Holdout for Value
“Price is what you pay. Value is what you get.” – Warren Buffett
— Audrey Caruso (@audrey_caruso) October 20, 2016
This one is trickier than it sounds. We all know that we should try to Buy Low and Sell High, but it is far easier said than done. Trust me, I’ve screwed this one up before.
Learn From My Mistakes
Ten years ago, I was working at a large financial institution when the Company’s stock price began to collapse. I had watched this stock trade within a small range for over two years. When the price dipped by 25% I bought a little. Then when it dipped by another 20% I bought a lot. It seemed like a great deal at the time.
Most folks do the same thing when they walk into a department store. These days there are Sale signs everywhere. 10% off here. 20% off there. Any smart investor would head over to Macy’s and start loading up. There’s just one problem…in almost every case you can’t simply walk into a retail store, buy a bunch of discount items and hope to sell them for more somewhere else. Large retailers are usually too smart for that. They have more information, resources, and experience than you do when it comes to selling to consumers.
But that doesn’t mean you can’t find a great value at the mall, if you know what an item is worth to YOU. The value of an item to you has almost nothing to do with the price. The price is simply a function of the cost to the seller and the value to the typical consumer. Note that the typical consumer may value a product very differently than you do at a particular point in time and frankly could just be valuing it wrong. If you want to be an above average investor then you can’t simply follow the crowd.
— LelaLatte_com (@LelaLatte_com) October 21, 2016
Suffice to say my great stock investment didn’t turn out so well. I had no basis for a valuation outside of where the stock had traded in the past. Thus when the stock fell further my confidence waned and I looked for the the first opportunity to exit. Good thing I did, since the price continued to crater and stayed there for the next few years. Admittedly the Great Recession was a unique point in time and big banks were notoriously difficult to value, but this mistake was driven by my overconfidence in the market price and lack of an independent valuation.
Luckily most real estate properties are much easier to independently value. They have the capacity to generate a stream of relatively stable income and they have certain expenses that must be paid. I use this simple idea as the basis for evaluating every property. My experience with rental properties gives me a ton of confidence that I can reasonable estimate the income potential and expenses for most properties. You will find that 60-75% of your average annual expenses are fixed. I can get pretty close on estimates for the remaining 25-40% and my margin of safety covers any mistakes.
- Property Taxes
- Property Management Fees
- Mortgage Expenses (if applicable)
- Eviction Costs
While nothing beats personal experience, for newer real estate investors there are lots of things you can do to learn how to properly value properties.
- Talk to local real estate professionals
- Network with experienced investors
- Leverage the market overviews and neighborhood guides on Remote-REI.com
- Consider better neighborhoods in the beginning in order to attract the best tenants
- Spend extra time and money on tenant screening and property inspections
- Start small. You’ll learn a lot on your first couple of properties, so don’t try to go from 0 to 60 properties overnight
Once you have the right assumptions for income and expenses you just need to decide on an appropriate return on investment and the math is relatively straightforward. I personally target 10% returns for all-cash purchases and 15% for purchases that I finance with a mortgage. Your return targets might be lower or higher. Just make sure the purchase will generate positive cash flow even after adding your margin of safety.
Never Compromise on Quality
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” – Warren Buffett
One word of caution as you focus on the first two principles. In your effort to search for the most undervalued properties that also provide a suitable margin of safety, don’t forget about the quality of your investment.
For real estate that boils down to: Location, Location, Location! You can have the worst house on the block with bad tenants and a lazy property manager and correct each of those issues over time. The one thing you can’t change is the location of your property. Buying a house in a desirable neighborhood can offset a lot of early mistakes and unexpected expenses. The potential for appreciation can also significantly boost long-term returns. The best neighborhoods also make it easier to find quality tenants that reduce vacancy and other real estate headaches.
Interestingly, Warren Buffett started his career with a more limited focus on quality. In fact, his namesake investment in Berkshire Hathaway is an example of the type of cheap, underwhelming companies that he targeted in his early days. Berkshire Hathaway was a stagnant Northeast cotton mill that was struggling to remain relevant in a commodity business where they no longer had a competitive advantage.
Buffett had management focus on streamlining operations and maximizing the cash flow generation of the cotton mills so that he could redeploy those funds into more attractive long-term investments. Although the Berkshire Hathaway name remains the cotton mills were closed long ago. In contrast with low quality businesses like the cotton mills, Buffett’s greatest successes have been in high quality companies like Coca-Cola and GEICO. Both companies had distinct advantages when Buffett began his investment career many decades ago and remain powerful brands with distinct competitive advantages even today.
I’ll admit that I struggle with this principle. I started investing in real estate in Detroit, MI. Detroit has a ton of positives for investors, but most of the neighborhoods are not in prime locations, have limited appreciation potential, and questionable long-term value. For reference, I rate every neighborhood that I invest in on a a scale from A to F. Most of my Detroit investments are in D and F level neighborhoods.
You can still make excellent returns in markets like this, but like Buffett I have come to believe that I need to balance my Detroit investments with some higher quality properties for the sake of my long-term portfolio. I may take a hit on my investment returns for the next 5 years, but for properties where I can use a mortgage for additional leverage, rent and sales price appreciation should definitely pay off in a big way over the next 10 to 15 years.
The key takeaway here is not to let short-term thinking cloud your investment judgment. If you’re investing for retirement or passive income than you need to ensure you are creating stable cash flows that will last for 20+ years. Even if you’re hoping to flip properties, remember that the individual that you’re selling to is looking for a long-term place to raise their family. Just make sure that in your search for great neighborhoods you’re not sacrificing any of the preceding principles.
Know What You Know (And What You Don’t)
“Never invest in a business you cannot understand” – Warren Buffett
Warren Buffett is an investing genius. It would be fair to say that he has above average intellect and a natural aptitude for evaluating complex business opportunities. Yet he purposefully focuses on simple businesses. Why? Where’s the challenge in that?
Specialize in a Few Areas
Investing is not like gymnastics. There are no bonus points for degree of difficulty. Masters of investing setup the game to win. Target opportunities with a limited number of variables and then focus your effort and intellect on understanding, mitigating, and quantifying those variables.
For the experienced investor, that means there are huge advantages to focusing on a market that you know well. That way it is much easier to spot the risks and quickly assess how that should impact your valuation and margin of safety. For the new investor or the experienced investor who needs to look at expanding to a new market that means you need a way to get up to speed quickly.
The answer: Focused Effort. There are no short-cuts. Buffett is famous for spending his early years learning about every large company and many small companies. This included reading everything that had been published and cold-calling management. Today information gathering is much easier with what is available on the internet, but there are no short-cuts. You still need to do tons of research and talk to experts live. Call brokers, call investors, call property managers.
Short on time? That doesn’t mean you can skip steps. You just may need to be more efficient in selecting the areas and strategies that you will focus on. Find investors who have similar investing philosophies and try to mirror where and how they invest. Maybe even consider partnering on the first deal to learn the ropes.
I’ve spent this whole section highlighting the importance of learning as much as you can about your desired investing strategy and market. However, all of that research will be useless if you don’t follow this next step.
Know What You Don’t Know
Know exactly what you don’t know. You spent weeks and months doing research and now you are ready to make that first investment. Now is not the time to get cocky. Overconfidence will lead to losses.
I already gave you one example with my bank stock investment earlier. Somehow I thought my finance degree, a basic understanding of how complex CDOs and derivatives worked, and reading half of an annual report (yes I admit that I never finished it, it was really long) made me an expert. Wrong!
Well I topped that mistake with my first few real estate investments. This time I did all the right things leading up to taking the plunge and making my first investment except for one thing. I decided to try a slightly different strategy than what my primary mentor was doing and I decided to try it on four properties simultaneously. It was an expensive education.
Now I’ll give myself a partial pass since my mentor was my dad and you can’t do exactly what your dad tells you, right. However I compounded that mistake with impatience and overconfidence. Both are counter to the Buffett investment philosophy.
You have to be brutally honest with yourself here while not letting the fear of failure stop you from ever making that first investment.
The reality is that I made my initial losses back many times over. So don’t get stuck in analysis paralysis. You can get a Bachelor’s degree with lots of research, but you’ll never get a Master’s degree in investing without Investing. Assume you’ll make many mistakes on your first few deals and just plan accordingly.
Be Ready to Hold Forever
“Our favorite holding period is forever” – Warren Buffett
— Trading Proverbs (@tradingproverbs) October 11, 2016
The final principle ties all of the others together. For those interested in Buy-and-hold investment strategies, this one should be easy. Buy as if you plan to hold it forever, but at least 10 years. If you do this, make conservative assumptions, and legitimately try to apply the other principles than you are likely to do very well over time.
Unfortunately there are still too many people hoping to get rich quick with real estate. The reality is that some folks with that approach will do very well and others will lose everything. For those following the Buffett Investment Philosophy, that is unacceptable. Remember Rule #1: “Never Lose Money”
But what about people interested in shorter-term strategies like wholesaling or flipping? Well Buffett bought and sold many investments within a relatively short time horizon early in his career when he had less money to invest. The key principle is that you should be willing and able to hold any investment that you make for the long-term even if you prefer to sell it quickly.
The old adage is that you make money when you buy not when you sell. Well the opposite is often true. You lose money when you sell. More specifically you often lose money when you are forced to sell.
Warren Buffett’s mentor was an investor and professor named Benjamin Graham who authored a book called the Intelligent Investor. In it he describes the basic advantage of the intelligent investor.
- Imagine you own a home
- Everyday Mr. Market sends you an offer on your home
- Most days that offer is within a reasonable range
- Some days Mr. Market goes a bit crazy and his offer is absurdly high or absurdly low
- Unfortunately his ridiculously low offers can stay low for a long-term and vice versa
- The intelligent investor can wait out these periods where Mr. Market is absurdly negative and capitalize when he is rational or overly positive
- The second you are forced to sell you lose your basic investing advantage and are now at the whim of a Mad Man
In real estate, the comps that we all look at in evaluating the market price represent Mr. Market. So when you hear what the comps are for a property, remember that they are not necessarily accurate, right, or rational. They are simply something to be taken advantage of when it suits you. Under no circumstances should they be relied upon as your sole valuation method.
Instead go do your own homework. Determine what you think the home is really worth based on cash flows and conservative assumptions. I would recommend valuing the property based on its value as a rental property. Now you may not be able to get a 30% margin of safety from the rental value of the property if you’re looking to flip it, but I would never advise paying more than that amount unless you are an experienced professional with enough other projects and cash reserves to absorb large unexpected losses on a property or two without derailing your overall portfolio.
How to Avoid Being a Forced Seller
- Don’t invest in too many properties at once
- Don’t rely on high interest hard money loans or credit cards to finance deals
- Maintain sufficient liquidity and cash reserves
Summing it All Up
“Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.” – Warren Buffett
— VV Investing (@Vintage_Value) October 20, 2016
The best investment strategies are simple to understand, but difficult to master. You want double-digit investment returns? Just follow these five simple steps:
- Margin of Safety: Unless you like losing money, always build in a healthy cushion. When you’re just starting off you’re guaranteed to make mistakes so build in an even bigger margin of safety
- Holdout for Value: You need a reasonable, conservative way to independently determine the value of each property. Do not rely exclusively on comps. Until you can do this, Don’t Invest.
- Don’t Sacrifice Quality: You can buy the worst house on the block, but stay away from the worst blocks in the city. Some experts can make money on these, but they come with more headaches and less long-term upside
- Know What You Don’t Know: It is difficult to learn everything you want to know about real estate investing, it’s even harder to admit what you don’t know. There are no bonus points for overconfidence.
- Be Ready to Hold Forever:. You make money when you buy and lose money when you’re forced to sell. Buy from motivated sellers, don’t be one.
You will have no trouble finding properties that meet two or three of these principles. The trick is having the patience and discipline to holdout for all five. The reward is worth it though. When you do find a property that meets this high bar, there are often dozens more in that same neighborhood.
Buffett has used this investment philosophy to earn 20% compounded annual returns over the last 50+ years. I’ve done the same with real estate over the last 10 years. Hopefully that is enough motivation for you to study and master this disciplined approach to investing.