What Benjamin Graham Can Teach You About Real Estate Investing
“Chapters 8 and 20 have been the bedrock of my investing activities for more than 60 years I suggest that all investors read those chapters and reread them every time-to-market is an especially strong or weak” -Warren Buffett speaking on the influence of the book The Intelligent Investor by Benjamin Graham
I have learned over time that my way is not always the best. I still don’t stop and ask for directions when I am lost. Yep…I am THAT guy. However, when it comes to finance I did not have role models. My dad was a hard working truck driver and my mom was a hairdresser.
In my search for a better roadmap in financial matters I have become hyper fascinated by the results of Warren Buffett. How exactly did he become so GREAT at making decisions?
I have come to believe success is better judgment on a daily basis. By withstanding the sound and the fury of day to day life and weeding through the onslaught of emotions and noise: successful people chose better choices.
So when Warren made such a bold statement, I stood up and did a lap around the laptop. In fact if Warren’s mind had a software program to make choices: much of it is contained in the great book by his mentor Benjamin Graham.
In this article today I will draw on Chapter 8 (The Investor and Market Fluctuations) and chapter 20 (“The Margin of Safety” as The Central Concept of Investment) to identify the key lessons from Ben.
I will suggest how real estate investors can apply them in screening a deal. Finally I will offer some ammunition for your private money presentation based on each chapter. But first I will give a brief history of Benjamin Graham and his influence on Warren Buffett.
Who is Benjamin Graham?
Ben graduated top in his class at age 20 from Columbia University and was offered professorships in mathematics, English, and philosophy but chose instead to work on Wall Street. He started an investment partnership a few years later and in 1928 he began teaching at the Columbia Business School and authored a cornerstone handbook for professional investors: Securities Analysis.
Ben coined the term Mr. Market for the sometimes outright insane stock market psychology. He suggested Mr. Market is always at your door making an offer: your key to success is having a math driven answer to what the whack job is offering you (my words not his LOL).
Warren Buffett’s lucky day, by his own admission, was when he picked up a copy of Intelligent Investor in 1949. Warren was so inspired by the book…he went to Columbia to study under Graham. A few years after he graduated he went to work for Ben on Wall Street before eventually striking out on his own. The rest is, as the say, history.
To illustrate how powerful Grahams methodology is Warren gave a speech on the fiftieth anniversary of the book Securities Analysis:
“During that speech, he presented his own investment record as well as those of Ruane, Knapp, and Schloss [other successful investment managers who were students of Graham at Columbia. In short, each of these men posted investment results that blew away the returns of the overall market. “ Source: Investopedia
So that begs the question: how can we us the concepts introduced by Ben and apply them to real estate? There are key similarities in stock selection and real estate and some interesting differences. I will take a stab at using the two chapters to get better results in real estate both in property selection and arguments you can present to why real estate should be in your investors basket of investments.
The Key Teachings of Chapter 8:
Ben’s main objective in Chapter 8 is to address market volatility – or in other words the degree of pricing that changes over time. For example, a market – stock market or otherwise – is highly volatile if it swings high and low at great speed.
Given that reality, the investor has two ways to profit from Mr. Market:
- Either by timing: anticipating when the market is going to yield a profitable price
- or via pricing
Which method yields the best result? Ben argues the use timing requires superior forecasting skills. Most average investors cannot dedicate time to that skill. Generally, Ben is skeptical on speculation generally.
The method that he advocates is the pricing method. By using the intrinsic value of an investment…or in other words calculating mathematically the estimated future cash flow of the entire business and then judging if you have to pay a premium to buy the cash flow or if it’s cheap relative to what’s it is intrinsically worth.
In essence, the market will irrationally assign values. That’s how you win against the field because in the long run- intrinsic value creates gravity and the price will trend up or down to it.
Another master tip in Chapter 8: In general, therefore buying in a bull market usually means paying too much for the cash flow of the business. Generally, the best approach is buy after bubble pops…wise out when fools rush in.
>Wise in when fools rush out. A bull market is characterized by:
- Historically high price level
- High P/E ratios
- High margin activity
- Low dividend yields against bond yields
- Large IPO activity of poor offerings
How Can I Use Chapter 8 to Make Better Real Estate Choices?:
The concept of value investing appears to have a very powerful result in real estate investing. A great example advocated by Craig Haskell in the CCIM magazine cited below recommends judging:
- What is the price compared to the replacement cost?
- If your purchase price is below it’s a great indicator of a value investment.
- If its above its generally a sign it’s time to develop instead
- What is the net present value
- If your NPV is greater than purchase price and any rehab cost then you have built in your WIN!!!
Is my market in a bull or bear phase?
Ammunition in Chapter 8 to Use in Your Private Money Presentations:
Many investors have experienced wide swings in their worth tied up in the market via investment or 401k. Volatility fatigue is a very real motivation to invest in real estate. Other key points:
- Real estate market timing is much more readily apparent.
- When combined with value investing you can almost lock in your wins.
It gets better:
- Value adding i.e. improving rental rates and occupancy increases intrinsic value. Can you do this with your stock investment?
The Key Teachings of Chapter 20:
The central thesis of Chapter 20 is that earnings power of the underlying stock will increase your margin of safety. In a sense, the underlying economic growth prospects of a company can increase your chances that you will not suffer an irreversible loss.
Ben is also a staunch advocate of diversification. Margin of safety principles are focused on avoiding a catastrophic loss.
How can I use Chapter 20 to make better real estate choices:
The rules from Chapter 20 in my mind would force us to consider:
- Don’t chase marginal deals
- If you buy below intrinsic value you will manage downside risk
- If you buy value add deals you are able to FORCE your margin of safety up!!!
- I love creative finance and VERY high leverage (Shout out to my friend Ben Leybovich) but high LTV's decrease our margin of safety
- I would argue that if you follow 1 through 3 you can outweigh the effects of very high LTV’s
Ammunition in Chapter 20 to Use in Your Private Money Presentations:
- Investors will add some protection from volatility with real estate in their portfolio
- Articulating your value investment policy specifically and clearly will demonstrate competence and truly fulfil a need!
- You will sleep better will GREAT deals in your portfolio
Overall, it seems to me we can duplicate others success if we ask: how precisely did they do that? What did they learn? How do I think like them? How do I make decisions like them?
Two Book Chapters that Changed Warren Buffett’s Life from Forbes
How to Value Invest in Real Estate by Craig Haskell