While these nicknames may be a little over the top (after all, he’s a humble guy that likes Cherry Coke and has lived in the same home for decades), it is fair to say that Mr. Buffett is one of the most successful investors of all time. What can we learn from his investing strategy that is applicable to real estate?
Today I want to focus on a specific quote of Mr. Buffett’s, as I believe the quote, while only 3 sentences long, is packed with information useful to real estate investors:
“The basic ideas of investing are to look at stocks as business, use the market’s fluctuations to your advantage, and seek a margin of safety. That’s what Ben Graham taught us. A hundred years from now they will still be the cornerstones of investing.”
Although this quote is related to stocks, if we make a slight modification, we can examine how it applies equally to real estate:
The basic ideas of investing in real estate are to look at investment properties as a business, use the real estate market’s fluctuations to your advantage, and seek a margin of safety.
Idea #1: Look at investment properties as a business.
We manage properties for many different types of owners. While some merely intend to lease their property for a short period of time, others would more accurately describe their rental property as long-term investment properties.
For this group of rental property owners, it is crucial to think of rental properties as a business.
Here are a few ways to do this:
1. Proper capitalization. The roof will need replacing, the furnace will go out, and the water heater too, all in the middle of winter and at the same time. Joking, but only partially. Business owners must make plans for the replacement of capital equipment and maintain the cash on hand to do so.
2. Understand expense ratio as it applies to rental properties. A business owner should be familiar with what percentage of gross income should be expected for expenses. This is important to set realistic expectations of net income and cash flow, and measure the performance of the property as an investment.
3. Remain committed to learning about real estate business operations. There are many important tax, accounting, and legal issues associated with rental property ownership. For some, it may be desirable to have professionals deal with these issues, but every rental property business owner should be comfortable with the basics. Start with IRS Publication 527 and the IRS tip sheet for tax / accounting topics. Pick up a good book with summaries of real estate law.
Idea 2: Use the real estate market’s fluctuations to your advantage.
Mr. Buffett also famously said, “A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful.”
Although Mr. Buffett was referring to stocks, this idea is also applicable to real estate. By looking at the ratio of acquisition prices to rent, investors can quickly get an overall idea of whether or not it is a good time to buy.
Take a look at the graph below. Put simply, it is a good time for buying when the blue line (acquisition price index) is below the red line (rental index). The larger the gap the better. 2006-2007 would have been a very bad time to purchase an investment property whereas 2012 was a great year to buy. The current spread shows that it still appears to be a good time to buy rental property, although the two lines appear to be slowly converging.
Idea 3: Seek a margin of safety.
A margin of safety allows a rental property owner to survive the inevitable downturns a local real estate market will encounter. There are several ways to create a margin of safety in real estate:
1. Maintain an operational cash reserve. By having a cash cushion above and beyond your capital reserves, an investor can replace the leaky roof and have enough money to cover the mortgage payment in case vacancy rates creep up and it takes longer than usual to rent the property or rental rates decline significantly.
2. Don’t over-leverage. During the real estate bubble leading up to the crash of 2007-2008, lenders were allowing ever-smaller down payments, even on rental properties. The payments on these loans likely created a negative cash flow situation, meaning that the owner would have to “feed the alligator” every month with cash from other sources. Although lenders have returned to more prudent underwriting standards (most purchases of rental property require a minimum 20% down payment), there will most likely be a time in the future where risky lending practices return. A mortgage broker’s assurance that jumping off a cliff is safe doesn’t make it so.
3. Own higher quality properties. Properties that are in high-demand school districts and good condition will survive a downturn better than lower quality properties in less desirable areas. People will always need housing, but when there’s a surplus of available housing, tenants will seek the highest quality properties that their monthly budget can afford.
In conclusion, good investment practices are applicable to both the stock market and the real estate market. By following his sage advice, you too can invest like Warren Buffett – in Real Estate!
I hope you have found this post useful. If you would like to discuss your property management and leasing needs with a professional, call us today at 918-665-0212, option 4.