Warren Buffett is probably the most successful investor of all time. He has compounded 20% annual returns for decades and amassed a fortune close to 100 billion. When he speaks, investors justifiably listen.
Buffett owes his success to a few key factors: quality, value, leverage, and management. He has put those factors to use over the past 60 years to build billions of dollars of wealth. In particular, he has used them to invest in stocks and whole businesses. Buffett has invested in bonds and derivatives here and there and his companies own a lot of real estate, but the focus has always been on stocks and businesses.
Partly because of that, Buffett hasn’t spoken highly about real estate investing. I think individuals can still have a lot of success here, and I think they can do it using Buffett’s methods. Let’s discuss how Buffett’s four investment factors can be used in real estate investing.
The turning point in Buffett’s investment career was when he started focusing more on the quality of his investments than just the valuation. He still kept value in mind, but business quality took on a major part of his analysis.
Quality is also of major importance in real estate investing. This doesn’t necessarily mean you have to buy the best and brightest buildings. Quality is the ability to generate above-average returns over the long term.
In real estate investing, that means always having a supply of potential new tenants. It also means being able to charge far more in rent than you pay to the bank and in property taxes. And it means not having to make major repairs every few months. A quality real estate investment is one that you don’t have to think about a lot. Both Buffett and Peter Lynch are fond of saying, “Buy a business that any idiot can run, because someday, one will.”
The backbone of Buffett’s analysis is value. Though he claims that he does valuation via a discounted cash flow (DCF) model, Buffett’s longtime partner Charlie Munger has expressed doubts that Buffett puts that much work into it. More likely, Buffett does a back-of-the-envelope valuation in his head based on current interest rates and earnings multiples.
It may seem impossible to find values in the current real estate market after a few years of prices running wild, but there are options for enterprising investors. Widening your circle of competence to learn how to invest in different types of real estate, like commercial or farmland, or even looking in different geographies, could open up more opportunities.
If you want to do it like Buffett, keep an eye on cap rates. When you’re looking at a new property, determine what the stabilized operating income level is for the property and divide it by the list price. That number is the capitalization rate. It can be compared to the coupon rate on a bond or the dividend yield on a real estate investment trust (REIT). Set a hurdle rate, something like 6%, and only invest if you can find deals above that rate.
For some investors, Buffett’s use of leverage may seem surprising. The other aspects of his strategy are all conservative. But it is not the type of leverage that you may be thinking about. Buffett uses the float from his insurance companies.
Insurance companies collect premiums all year-round and can invest that cash until it has to be paid out in claims. Buffett’s Berkshire Hathaway owns several insurance companies, and he invests the float to great effect.
Real estate is the best asset class for individual investors to use leverage. It’s normal for real estate investors to put 20%, or even less, down on real estate investments without taking on a lot of risk. Over time, real estate prices are far more stable than stock prices and produce the cash flow that makes the debt payments.
Like the leverage he’s used, the quality of management that he’s worked with is an often-overlooked aspect of Buffett’s success. From Ajit Jain to Greg Abel, Buffett has a great talent for identifying good managers and then, possibly more importantly, staying out of their way.
There is a clear parallel to this in real estate investing. Most real estate investors would be better off using property managers, who have the local knowledge to find the best tenants and charge the highest rent. They have the networks to do cleaning and repairs quickly and efficiently. And they have the time to do inspections to ensure that tenants aren’t wreaking havoc on the property.
Take the time to evaluate a few local property managers, and you’ll be thankful when something big comes up that you don’t have to deal with.