Mortgages & Creative Financing

What Benjamin Graham Can Teach You About Real Estate Investing

Expertise: Real Estate News & Commentary, Business Management, Personal Development, Mortgages & Creative Financing
30 Articles Written

“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?

    • California running up to fast in SFR’s?

    • Multifamily too hot? Overbuilding in certain markets?

    • Not sure on either but suggesting caution

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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:

  1. Don’t chase marginal deals
  2. If you buy below intrinsic value you will manage downside risk
  3. If you buy value add deals you are able to FORCE your margin of safety up!!!
  4. I love creative finance and VERY high leverage (Shout out to my friend Ben Leybovich) but high LTV's decrease our margin of safety
  5. 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

Photo: Capa_r2

Douglas Dowell J.D. is a commercial and multifamily investor. His blog will focus on legally raising private money, risk mitigation with due diligence and management science. He is also an avid student of success principles with a focus on modeling success factors.
    Jeff Brown
    Replied over 7 years ago
    Absolutely superior stuff, Douglas. Thanks so much. I’d love to hear your thinkin’ on Buffett’s apparent departure from his mentor as it relates to diversification. I’ve read many times that Buffett thinks, loosely paraphrased, ‘. . . that diversification is for people who don’t know what they’re doing.’ Again, what a high quality post.
    Douglas Dowell
    Replied over 7 years ago
    Thank you Jeff, I tend to agree with Warren. Carnagie felt much the same way too. If you focus your protection and care by being hyper vigilant about the forces and facts around your particular favorites then you achieve a similar or really superior results. It comes down to the information advantage. The key is how much time do you have to devote to market research. Diversification is perhaps for the average investor???
    Jeff Brown
    Replied over 7 years ago
    Is that your way of saying the average investor doesn’t know what they’re doin’? 🙂 The problem is that as investors learn through experience, both good and bad, they often don’t realize that learning more and more answers to their list of questions isn’t the solution. It’s realizing they still don’t know too many of the questions.
    Douglas Dowell
    Replied over 7 years ago
    LOL…perhaps. For me the greatest discovery is about having a discipline. I think the average investor gets DESTROYED is the inability to be emotionless in decisions. The book really opened up my eyes to that fact. Zen in the art of investing….that true success is being completely independent in decision making based on a math driven answer.
    Replied over 7 years ago
    You see this from Buffet but Berkshire is pretty well diversified. The company wholly owns GEICO, BNSF, Lubrizol, Dairy Queen, Fruit of the Loom, Helzberg Diamonds and NetJets, owns half of Heinz, owns an undisclosed percentage of Mars, Incorporated Equities – beneficial ownership[edit] This includes some of the companies where a Berkshire Hathaway stake is more than $1 billion market value at the end of the year, as reported in the 2011 annual report.[48] In alphabetical order: American Express Co. (13.7%) BYD (9.9%) The Coca-Cola Company (8.9%) IBM (6.0%) Kraft Foods (4.5%) Moody’s Corporation, owner of Moody’s Analytics (12.5%) Munich Re (10.5%) Wells Fargo (8.7%) Wal-Mart (1.1%) Bonds[edit] As of 2008, Berkshire owns $27 billion in fixed income securities, mainly foreign government bonds and corporate bonds.[ This is just from Wikipedia so can’t fully comment on the accuracy. Assuming this is more or less correct that is a lot of companies that do a lot of different things. I think his statement is more that when drones just buy random mutual funds since they give you diversification they don’t know what they are doing. He is diversified but it is because he buys companies, or large stakes in them, in different industries and creates his own mutual fund from individual investments that he identifies as great value.
    Ziv Magen
    Replied over 7 years ago
    Superb article, Douglas, thank you – I immediately went and bought the digital version of the book 🙂 To pipe in on the diversity discussion – I think diversity has many forms. To take our own family investment strategy as an example – we feel that real estate is what we know and do best, so we haven’t diversified our investment sectors – but that hasn’t stopped us from diversifying geographically over several cities, countries and continents, as well as in form – bricks and mortar, notes, REITs etc – I’m sure you can all think of several “non-diversified” diversifications, in whatever sector you may be primarily invested – as I’m sure Buffet does, too.
    Douglas Dowell
    Replied over 7 years ago
    Thank you Ziv, I think your right..diversity within your category of expertise is the best of all worlds. No one particular project can sink you and you take advantage of your superior knowledge.
    Ben Leybovich
    Replied over 7 years ago
    Right on Douglas! What you’ve described is the essence of Fundamental Investing. This is the essence of expandability in Expandability. Great stuff!
    Ben Leybovich
    Replied over 7 years ago
    Right on Douglas! What you’ve described is the essence of Fundamental Investing. This is the essence of expandability in Expandability. Great stuff!
    Douglas Dowell
    Replied over 7 years ago
    Thanks Ben! It really does seem to validate high LTV’s..IF the intrinsic upside is there. I see why you are soooo selective.
    Mehran Kamari
    Replied over 7 years ago
    I really enjoyed reading this article. Thank you Douglas!
    Douglas Dowell
    Replied over 7 years ago
    Thank you Mehran! Its been a interesting journey to reverse engineer Warren Buffett’s results.
    Ankit Duggal
    Replied over 7 years ago
    Great takeaways from Benjamin Graham writing.
    Douglas Dowell
    Replied over 7 years ago
    Thank you Ankit…its really game changing info.
    Replied over 7 years ago
    Excuse me if I come across as a uninformed, but what is LTV?
    Douglas Dowell
    Replied over 7 years ago
    No worries Frank, LTV=Loan to Value is a rough benchmark on how much debt the lender is willing to carry as a part of your capital stack. It tends to fluctuate with conditions and willingness to fund. For example 75% to 80% is possible in the multifamily space where in getting a loan for an Office building my guess is it would be tough to get north of 65%. Loan to Value implies an existing structure where Loan to Cost is used when speaking of a new build as a percentage of debt funding available.
    Replied over 7 years ago
    One addition to the LTV comments is that people do use that term pretty interchangeably when talking about actual value and purchase price. I am now speaking mostly residential as that is where most of my experience is. When purchasing a property if they will do an 80% LTV loan that means 80% of the lesser of the appraised value or the purchase price. (This is only relevant to traditional bank financing) For example if you have a contract to buy a place for $400K and it appraises for $500K they will loan you 80% of the $400K. Same deal but it appraises for $390K then they will only loan 80% of $390K and you either need to get the seller to agree to the lesser price or bring the difference to the table (Or take a hint and get out of this “deal”). If you bought the really good deal in scenario 1 and after some time went to refi and it still appraised for $500K you could get an 80% loan on that value and get $400K back to get your down payment money out. Someone like Ben doesn’t do 100% LTV he buys undervalued assets with 100% of the purchase price but has an equity cushion and makes sure the terms allow for good cash flow from day 1. That is a much different animal than paying retail and putting no money into the deal.
    Replied over 7 years ago
    I can actually see myself utilzing the principles you had highlighted from the ‘Intelligent Investor’ book and others from it. I don’t know if you read the book, but if you did could inform me whether or not that it has a Real Estate Section for Investing; I assume it doesn’t, and mainly accompanies info on capital gains involving stocks.
    Replied over 7 years ago
    Sorry I missed this one Frank. Unfortunately Ben did NOT evaluate real estate investment. I think the best effort is to do an NPV analysis to get a close equivalent to the same method Ben is talking about. Takes some digging to use the same approach but I think its there for the taking.