If you’ve ever longed for real estate investing advice from the “Oracle of Omaha,” your wait is over. In his latest shareholder letter (released March 1st, 2014), Warren Buffett shares the details and lessons learned on two of his real estate investments that – spoiler alert – were wildly successful.
Real Estate Investment #1 – Farmland
Mr. Buffett purchased 400 acres of Nebraska farmland in 1986 from the FDIC at a fraction of the property’s prior loan balance. Investment results: 28 years later, the farm’s earnings have tripled and the property is worth 5 times more than what Mr. Buffett paid. Smoothing out the cash flow growth over the hold period, this would equate to an estimated 15% unleveraged return.
Real Estate Investment #2 – Retail Building
The second real estate investment discussed is a New York City retail property that Mr. Buffett purchased with legendary NYC real estate investors Larry Silverstein and Fred Rose. The partnership acquired the property in 1993 from the Resolution Trust Corporation, the entity that was created to liquidate bank owned real estate and distressed loans stemming from the savings and loan crisis. Under the RTC’s supervision, the retail building was floundering as the largest tenant’s rent was substantially below market, which was a temporary constraint on earnings. Investment Results: annual distributions now exceed 35% of the partnership’s initial equity investment and the property was refinanced twice, enabling the partners to take special distributions totaling more than 150% of their initial investment. It’s always more fun when you’re playing with the house’s money.
Here are some quotes from the shareholder letter regarding these investments followed by my own takeaways:
“You don’t need to be an expert in order to achieve satisfactory investment returns”
I would guess that Warren knows very little, if anything, about running either a farm or a large retail property. Case in point, he’s never seen the NYC retail investment and he’s been to the farm twice in 28 years. However, Mr. Buffett is certainly savvy enough to recognize an investment opportunity and partner with expert operators to execute a turnaround strategy. As a real estate investor, you have to be willing to invest outside of your home market and trust your team if you want to achieve superior returns. Don’t let proximity dictate your acquisition targets.
“Focus on the future productivity of the asset you are considering”… “If you instead focus on the prospective price change of a contemplated purchase, you are speculating.”
This is a great reminder for real estate investors. Just focus on cash flow, forget the residual sales price forecast. This is difficult to do when you have a shorter duration investment, but if you’re able to hold a property for a longer horizon, don’t worry about the exit cap rate projection (assumed sale price). When pushing to win a deal, it’s too tempting to try and make a higher offer price work by fiddling with the back end cap rate (just ask California trophy apartment investors buying sub 4% cap rates). Instead, focus on the controllable – the property’s stabilized cash flow – when analyzing a prospective deal.
“Those people who can sit quietly for decades when they own a farm or apartment house too often become frenetic when they are exposed to a stream of stock quotations and accompanying commentators delivering an implied message of “Don’t just sit there — do something.”
The illiquid nature of real estate is often cited as a negative. However, this illiquidity protects investors from themselves and their emotions. If CNBC told you that the value of your rental property plummeted by 30% today due to a flash crash, you couldn’t panic sell even if you wanted to. Provided you don’t over-leverage, it is much easier to stay the course (buy & hold) with investment real estate than volatile stocks, where paper losses are just as painful as actual losses.
“Income from both the farm and the NYC real estate will probably increase in decades to come. Though the gains won’t be dramatic, the two investments will be solid and satisfactory holdings for my lifetime and, subsequently, for my children and grandchildren.”
I don’t know about you but this sounds pretty good to me. I invest in real estate precisely for this reason; I believe it represents the best opportunity to build a legacy of passive income for my family. This might sound daunting, but to Mr. Buffet’s point, you don’t need dramatic gains or even amazing deals to achieve this. Thanks to real estate’s generous tax advantages (depreciation, 1031 exchanges, etc.), rent inflation and forced debt reduction (through amortization), even modest portfolios can provide ample income for your retirement and heirs.
Two additional lessons learned from Warren’s real estate investments:
1. Banks and loan servicers hate seeing real estate on their books for a reason, they’re horrible investors.
Not only are they willing to liquidate balance sheet holdings at fire sale prices, the bank’s asset mangers typically do a lovely job of reducing earnings while the property is under their control. Often these managers / servicers miss easy opportunities to maximize cash flow because they are working a large pool of properties just trying to stoop the bleeding. This leads to easy operational improvements for an active, professional real estate investor that can buy a bank owned property (REO), inject a little equity for capital and tenant improvements and dramatically increase occupancy and thus property value.
2. It’s hard to get hurt when you’re buying properties that offer normalized 10% unleveraged returns.
It’s implied that both the farm and the retail building were underperforming at the time of purchase, but both assets were projected to deliver 10% yields under typical operating circumstances. Focusing on what Buffett likes to call, normalized earnings, enables real estate investors to recognize buying opportunities. When buying real estate, the current cap rate is typically the headline. However, most people are blinded by the circumstances of the present (or recent past) and overweight the probability that the situation will remain the same. While its always difficult to buy after dramatic decreases in prices, if you can see a clear path to stabilized occupancy / earnings, pull the trigger – major real estate downturns don’t occur every year.
I’m certain there are 10 additional lessons in these two case studies that I’ve overlooked. But that’s the genius of Buffett – his advice seems light and plainspoken, yet the teachings run deep. You might not feel the same, but I was thrilled to read some of Warren’s thoughts on real estate investing. As a professional real estate investor, I’ve often felt cheated that the world’s greatest investment mind has spent a lifetime sharing his invaluable wisdom on the stock market while the real estate world is stuck with Donald Trump and whatever he happens to be selling. At least we had professor Buffett for a day.
Photo Credit: Mark Strozier