As co-host of the How to Lose Money podcast, you may think I’m just going to say that “losing money is the surest way to destroy your real estate career.”
Many of us believe that real estate investing is the best path to long-term wealth available on the planet. If that’s true, then…
Why Do so Many People Lose Money in Real Estate Investing?
Last week I wrote about Warren Buffett’s margin of safety concept. A lot of people commented, and it’s spurred some more thoughts on the topic.
Let’s start with a few quotes from the man himself.
“We insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we’re not interested in buying. We believe this margin of safety principle, emphasized by Ben Graham, to be the cornerstone of investment success.”
Buffett is my investing hero. Graham is Buffett’s hero. Graham wrote the epic book Security Analysis, and Buffett synthesized Graham’s thoughts to create a legendary fortune. As I’ve said before, we would be foolish to ignore Buffett’s advice to us as real estate investors.
Key Investment Insight from Buffett
“You calculate—I think you take all of the variables and calculate them reasonably conservatively. But you don’t try and put too much windage in at every level. And then when you get all through, you apply the margin of safety. So I would say, don’t focus too much on taking it on each variable in terms of the discount rate and the growth rate and so on. But try to be as realistic as you can on those numbers, but with any errors being on the conservative side. And then when you get all through, you apply the margin of safety,” he said in 2004 at Berkshire Hathaway’s annual meeting.
Other Important Buffett-isms
- It’s one thing to buy something for less than its value, but it’s another to buy something for much less. Given that the value of something is an estimate, wouldn’t you rather purchase far below your estimated value as opposed to cutting it close just to get a “deal”?
- Why is this the cornerstone of investment success? Because your chance of losing money decreases, and losing money is the surest way to destroy your real estate investing career. (Did I hear you call me “Captain Obvious”?)
- You must protect your original capital, and the best way to do this is by buying with a margin of safety.
- Buffett relies on the margin of safety to follow his own first rule of investing: never lose money.
Avoid These Margin of Safety Mistakes
Remember 2008? Some of you might. Many folks back then didn’t have a margin of safety built into their real estate purchases. Acquiring inflated properties with zero down, interest only and adjustable rate debt will often come back to bite you. It surely bit many during the Great Recession.
I fear many of today’s new gurus (let’s coin a new phrase and call them “Newrus”) either forgot these lessons or weren’t even in real estate a decade ago. Don’t fall prey to their Newru-ness. (I like this new word.)
Take a multifamily property as an example. When purchasing a 100-unit, value-add property, you must have a solid business plan in place with conservative estimates. If you don’t, your margin of safety may be thin, and any unforeseen issues may wreck your plan.
What are some factors that could result in too thin of a margin of safety in this multifamily deal?
- Assuming a certain rent growth to make your plan work
- Assuming 98 percent (or higher) occupancy (“Who wouldn’t want to live here?”)
- Assuming market rent growth (from inflation) at a much higher rate than operating costs (also based on inflation)
- Assuming few to low capital expenses (Yes, I know your place is nicer than all the others Mr. Newru)
- Banking on interest rates to be steady when you go to refinance your bridge loan
- Assuming you’ll only have wonderful tenants and never have an expensive eviction
These are just examples. There are many other possibilities. Like we discussed in a prior post, Buffett teaches us to zero in on a handful of key factors and spend extra time understanding those well.
What are your key variables?
How Margin of Safety Can Inform Your Investing Strategy
Many smart fund managers focus on generating income first and consider appreciation as a bonus. This thinking is in line with Buffett’s margin of safety. Do you see how?
Which of these two theoretical funds would you rather invest in:
- Investment 1: Total target return of 15%.
- Breakdown: Income generated by current operations = 11%. Target return from theoretical appreciation = 4%.
- Investment 2: Total target return of 20%.
- Breakdown: Income generated by current operations = 3%. Target return from theoretical appreciation = 17%.
Many people would choose the second investment option, with a target return 33 percent higher (20 percent vs. 15 percent), and there is nothing wrong with that.
If the operators and fund managers have a solid business plan and a track record of prior success, then perhaps this is the one I would choose, too.
But a lot of experienced investors would choose the first investment option. A more predictable return from current operations is often of greater importance to seasoned investors than the theoretical returns that will be generated from value-add and development.
When applying a significant risk factor to the unproven income stream from investment No. 2, the returns may look similar anyway.
Thinking about the margin of safety with regard to this situation enables investors to more critically evaluate the returns. While some margin must be applied to current income, a quite higher margin applied to the theoretical income allows for a better assessment of the situation and will often lead to a better outcome.
How Margin of Safety Applies to Asset Class Selection
My firm is launching two investment funds right now. One is a growth fund aimed at appreciation with no goal of producing income. This fund invests in steep value-add projects and ground-up developments with experienced operators in self-storage and multifamily.
The other is an income fund aimed at producing steady income with appreciation (as a cherry on the sundae). This fund focuses on currently operating manufactured home communities and self-storage facilities, with the possibility of buying stabilized multifamily, as well.
When we were choosing asset classes for each of our funds, we had the choice of self-storage and mobile home parks. (We are rarely investing in multifamily right now, as I’ve often discussed. We feel it’s become somewhat overheated.)
Self-storage assets can be (1) ground-up developments, (2) value-add deals, or (3) stabilized cash-flowing assets.
Manufactured home communities (aka mobile home parks) are virtually always stabilized cash-flowing assets.
Since the income fund is focused on stable, predictable, immediate income, it was easy to decide what assets fit there: manufactured home communities and stabilized self-storage facilities.
Our growth fund is willing to take some more risk to fast-track appreciation. With no need for current income, the obvious choices were ground-up and value-add self-storage deals. Mobile home parks wouldn’t make much sense here.
A significant margin of safety must be applied to the growth fund since there is more risk involved. So, let’s say we invest with an operator that has generated annual total returns of over 40 percent with three-year projects over the past two decades.
When applying the margin of safety, we ask ourselves:
- What if cap rates move against us?
- What if interest rates increase when we go to refinance or sell in three years?
- What if it takes six years instead of three?
- What if a new competitor comes online while we’re in the midst of building and leasing our facility?
- What if lease rates can’t be raised as planned?
Then, we take the theoretical projected return and slash it, say, in half. Next, we double the time horizon. And then, we use this as a projected return for this asset. If the numbers still look good (half the returns in double the time), we could have a winner on our hands—a candidate for a great investment for our growth fund.
Interested in Finding out More? Reach out below
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