Warren Buffett is probably the most successful investor of all time. He’s racked up 20% annual returns for decades and amassed a fortune approaching $100 billion. When he speaks, investors rightly listen.
Buffett owes his success to a few key factors: quality, value, influence, and management. He has used these factors to build billions of dollars in wealth over the past 60 years. In particular, he has invested in stocks and entire companies. 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 companies.
Partly for this reason, Buffett hasn’t talked much 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 investing career came when he began to focus more on the quality of his investments than just valuation. He still kept an eye on value, but company quality took up a large part of his analysis.
Quality is also of great importance in real estate investments. That 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.
When it comes to real estate investments, this means always having a supply of potential new tenants. It also means you can charge a lot more rent than you pay to the bank and 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 much about. Both Buffett and Peter Lynch like to say, “Buy a business any idiot can run, because someday someone will.”
The backbone of Buffett’s analysis is value. Though he claims he runs the valuation using a discounted cash flow (DCF) model, Buffett’s longtime partner Charlie Munger has expressed doubts that Buffett is putting that much work into it. More likely, Buffett is running a back-of-the-envelope assessment in his head based on current interest rates and earnings multiples.
It may seem impossible to find value in the current real estate market after a few years of wild prices, but there are options for enterprising investors. Expanding your circle of skills to learn how to invest in different types of real estate such as commercial or farmland, or even searching in different regions may open up more opportunities.
If you want to do like Buffett, keep an eye on cap rates. When looking at a new property, determine what the stabilized operating income is for the property and divide it by the list price. This number is the capitalization rate. It can be compared to a bond’s coupon rate or the dividend yield of a real estate investment trust (REIT). Set a minimum rate, say 6%, and only invest if you find deals above that rate.
Buffett’s leverage might come as a surprise to some investors. The other aspects of his strategy are all conservative. But it’s not the kind of leverage you might think of. Buffett uses his insurance companies’ float.
Insurance companies collect premiums all year round and can invest this money in claims until it is paid out. buffets Berkshire Hathaway owns several insurance companies and invests the float with great success.
Real estate is the best asset class for retail investors to use leverage. It is normal for real estate investors to bet 20% or even less on real estate investments without taking much risk. Over time, real estate prices are far more stable than stock prices, producing the cash flow that pays off debt.
Like the leverage he’s worked with, the quality of the management 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, perhaps more importantly, avoiding them.
There is a clear parallel to this in real estate investment. Most real estate investors would be better off hiring property managers who have the local knowledge to find the best tenants and charge the highest rents. They have the networks to carry out cleaning and repair work quickly and efficiently. And they have the time to conduct inspections to make sure the tenants aren’t trashing the property.
Take the time to evaluate a few local property managers and you’ll be thankful if something big comes up that you don’t need to deal with.