Did you ever notice that Warren Buffett seems to make very few bad investments?

On September 23, 2008 Mr. Buffett’s company, Berkshire Hathaway, invested $5 billion in Goldman Sachs preferred stock. Goldman offered a 10% annual return on the investment in preferred shares, $500 million per year. In addition, Berkshire Hathaway was given the option to buy $5 billion in common stock at a price of $115 per share. One year later the investment would have returned almost $3.1 billion to Berkshire Hathaway not including the annual, perpetual return on the preferred shares. (As of January 8, 2010 the investment would be worth $2.58 billion at $174.31 per share.) This is a return of 40%-60% in one year!

View Your Investment as Ownership of a Business

Warren Buffett writes in his 2008 letter to Berkshire Hathaway owners:

We like buying underpriced securities, but we like buying fairly-priced operating businesses even more.

In his 2007 letter to investors Buffett writes:

Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag. We like to buy the whole business or, if management is our partner, at least 80%. When control-type purchases of quality aren’t available, though, we are also happy to simply buy small portions of great businesses by way of stockmarket purchases. It’s better to have a part interest in the Hope Diamond than to own all of a rhinestone.

A real estate investor must realize that they are buying a business when they buy rental property. Businesses must market and sell a product to customers that are ready, willing, and able to buy in order to make a profit.

As a real estate investor your product is space and your customers are your tenants. For the apartment or multi-family owner their product is living space. The retail real estate owner offers storefronts to other businesses. The office building owner offers other businesses office space.

A successful real estate investor will market the space to their customers or tenants. An investor must offer it for a reasonable price or the tenants will not be interested. Investors must decide which tenant is most likely to rent the space and advertise where that tenant will see their advertisement. Maintaining a property that is appealing to potential tenants is part of the business of real estate.

A stock investor must analyze the competitive strength of the business they are buying. Will it be protected from outside competition? Does it have adequate cash flow? What is the demand for their products? What event may damage their business? How likely is that to occur?

Real estate investors should ask the same questions about their real estate investment. Is this property above or below the competition? Are new developments coming on line? If so, how will that affect my investment property? What economic factors contribute to the health of the local economy? Do people want to live near my investment? Who are the major employers?

Invest Based Upon Value Not Price

Warren Buffett learned much of his investment philosophy from Benjamin Graham, author of The Intelligent Investor. Benjamin Graham stressed value investing. In Mr. Buffett’s most recent letter to Berkshire Hathaway investors and this quote was on page 5:

Additionally, the market value of the bonds and stocks that we continue to hold suffered a significant decline along with the general market. This does not bother Charlie and me. Indeed, we enjoy such price declines if we have funds available to increase our positions. Long ago, Ben Graham taught me that “Price is what you pay; value is what you get.” Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.

Two things stand out from this quote. First, value is more important than price. If you invest in a piece of junk with no lasting value, it doesn’t matter what price you pay for it. Inversely, what price would you pay for the Hope Diamond or the Mona Lisa?

Mr. Buffett describes intrinsic value in the Berkshire Hathaway owner’s manual on page 5 as “the discounted value of the cash that can be taken out of a business during its remaining life.” Mr. Buffett goes on to say that intrinsic value may very from one investor to the next and even varies between himself and Charlie Munger, his business partner.

In real estate, investment properties provide cash flow through rent and offer the owner the ability to sell at a future date. Once the value of these cash flows has been determined (through discounted cash flow analysis), an investor can determine a price at which the value is worth an investment.

Second, price declines are advantageous to investors with cash to acquire new real estate. Price declines make valuable real estate more affordable.

Distressed markets do not function efficiently. Usually, this means that there is a shortage of willing and able buyers. Sellers are forced to compete on price for the few available buyers. Prices continue to drop until a willing and able buyer is interested to buy. This shortage of buyers leads to fear and further limits the entry into the market for new buyers.

Distressed markets also have a shortened time-frame. Sellers need to sell quickly or raise capital quickly. This provides unique buying opportunities for the savvy investor with cash available to scoop up discounted properties quickly.

If Possible, Use Other People’s Money

One of Berkshire Hathaway’s first purchases was National Indemnity, a property-casualty insurance company. Insurance continues to be one of Berkshire Hathaway’s major income sources. In Berkshire Hathaway’s 2004 investor letter Buffett writes this:

The source of our insurance funds is “float,” which is money that doesn’t belong to us but that we temporarily hold. Most of our float arises because (1) premiums are paid upfront though the service we provide – insurance protection – is delivered over a period that usually covers a year and; (2) loss events that occur today do not always result in our immediately paying claims, because it sometimes takes many years for losses to be reported (asbestos losses would be an example), negotiated and settled. The $20 million of float that came with our 1967 purchase has now increased – both by way of internal growth and acquisitions – to $46.1 billion. [emphasis added]

In real estate using other people’s money is typically accomplished through the use of a loan. A real estate investor invests a portion of the funds necessary to invest and a lender lends money to the investor for the balance of the purchase price.

Investors often call this leverage. Using a small amount of capital, the investor’s equity, to buy a larger asset. The “lever” is the loaned money. This concept allows an investor to earn a return not just on their capital, but also on the money they have borrowed.

The concept of leverage only works if the borrowed money is less expensive than the return generated by the asset. It is hard to make a profit borrowing money at 12% and investing it for a 10% return.

Pick Management Wisely

One of the the things Mr. Buffett has done extremely well is buy operating businesses. He selects businesses that have excellent management in place. Warren Buffett realizes the value of a quality management team and the benefits it offers to ownership.

In the 2004 Berkshire Hathaway letter to investors Buffett shares his instructions to his business managers:

“Run your business as if it were the only asset your family will own over the next hundred years. Almost invariably they do just that and, after taking care of the needs of their business, send excess cash to Omaha for me to deploy.”

Real estate investors should choose their property management companies wisely as well. A good manager will keep a property well-maintained and full of quality, paying tenants. A poor manager may cost an owner less, but may allow properties to become run down or allow unfit tenants to lease your property.

Feel Free to Say “No” to Opportunities You Don’t Understand

Mr. Buffett is not afraid to pass on investments that he doesn’t understand, even though he may “miss out” on some great investments. Mr. Buffet has repeatedly admitted that he doesn’t understand technology companies, and doesn’t regularly invest in them. This saved his company from incurring some huge losses during the Technology Bubble in the stock market.

Real estate investors should avoid investments that they don’t understand. If an opportunity sounds “too good to be true”, it probably is.

Apply a “Margin of Safety”

A margin of safety limits the risk of an investment. Benjamin Graham, Warren Buffett’s mentor, dedicated an entire chapter in his book, The Intelligent Investor, to the concept of a “Margin of Safety”. Graham writes:

In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, “This too will pass.” Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.

Simply put, a margin of safety is room for error. If you think a stock is worth $12, pay $10 instead of $11.50 to guard against a miscalculation of value. Unless you are God, eventually calculations on future events are going to be wrong. A margin of safety helps to preserve your investment when your calculations are incorrect.

As real estate investors, we make many of our determinations based on assumptions about income to be received in the future. Applying a margin of safety allows us to invest with room for error should our assumptions be wrong. Recessions, plant closures, and natural disasters all affect real estate, but cannot be predicted. A margin of safety provides a buffer against these unforeseendisasters.

Conclusion

Real estate investors can benefit from the principles of stock investors like Warren Buffett. Viewing investments as a business, investing based upon value, prudently using leverage, picking management wisely, avoiding confusing investments, and applying a margin of safety will help real estate investors to invest with confidence in any type of markets.