How to Use a Margin of Safety to Avoid Financial Disaster (The Buffett Series)
We real estate investors love to focus on profits, cash flow and big checks. But if you want to be more than a one-hit wonder, you should follow the advice of investors who have survived and thrived a long time — through up and down markets.
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The best longterm investor I know of is Warren Buffett, and he has two simple pieces of advice that will keep you around for a long time:
- Don’t lose money
- Don’t forget rule #1
For Buffett and other value-oriented investors, the name of the game is to not lose the hard earned money it took a long time to accumulate. Buffett acknowledges that years of successful investing can all be wiped out with just one major blunder. Financially and psychologically, this type of setback can make it hard to ever recover.
So value investors would rather steadily climb and avoid dangerous pitfalls than to take the quicker, but more dangerous route right along the edge of the cliff.
Related: 3 Business Tenets Necessary for Intelligent Real Estate Investing (The Buffett Series)
Another way of thinking about this investing philosophy is to measure your risk (possible disasters) more than you measure your reward (profits, equity, cash flow).
There are a couple of ways to apply this philosophy. First, as I wrote before, you have to avoid popular, dangerous, lemming-like trends. Second, you have to do what Buffett’s mentor, Benjamin Graham, summarized almost 80 years ago as a core investing strategy: to invest with a margin of safety.
Margin of Safety Investing
A margin of safety basically means that you don’t pay full price.
Why? Because even the best investors are lousy at predicting what an investment is really worth. The future is uncertain, and no one is smart enough to predict it exactly. So a margin of safety is a cushion that acknowledges and allows for our imperfection and the economy’s uncertainty.
Market price is not always the same as its true, intrinsic value. Market price could be higher, or it could be lower. Our main job, then, is to hunt for those deals that for some reason can be bought below value.
3 Margin of Safety Filters for Real Estate Investing
Because real estate is very local and relatively illiquid, I find it much easier to buy with a margin of safety than with public stocks or other investments. Here are three margin of safety filters that I like to apply to my potential deals.
Filter #1: Can My Deal Survive at Wholesale Prices?
Residential real estate markets differ from stock markets in crucial ways. With stocks, millions of people buy and sell a company each day. With real estate, ONE person might buy a certain property every 5 years or more!
Stock pricing is very accurate based on constant "votes" from the market. Real estate pricing is a best guess of an appraiser or real estate agent.
Stocks can be sold in minutes. Real estate takes months or years.
Yet, even real estate, if priced low enough, can be sold VERY quickly — in a matter of days. So at wholesale prices (and not retail prices) real estate behaves more like the stock market.
Think about the house that you live in. The retail “value” might be $175,000, but it would take months to sell at that price. Isn’t there a price low enough that a cash investor in your area would buy it in a few days? What about $125,000? Or $100,000?
If your total investment is less than this wholesale price, you have significantly reduced your risk of loss because worst case (at least in the current market), you could just dump it to an investor and get your money back.
It’s not hard to figure out that wholesale price point for almost any piece of real estate. If you need help and want to sell your own property in days, just give me a call. 🙂
Or better yet, ask your investor friends what they would pay for your residence or for some of your investments. Don’t be insulted. It’s just helpful information.
With my own purchases, I figure out this wholesale price before I decide to buy. For example, with a fix-flip deal, I calculate two different purchase prices.
First I figure out my higher, retail price that I hope to sell it for. I use this to back out a purchase price that will allow me to make my minimum profit goal. Secondly and more importantly, I also attempt to figure out the wholesale price. I want to make sure my total purchase investment will be at or below this lower price. If it is, I feel better about speculating on the retail price because I have a margin of safety in a worst case scenario.
I also would like to pay less than this wholesale price with rental purchases, but sometimes with longer-term rental properties I might still choose to pay more than wholesale if it also meets my criteria #2 and #3 (below). Even in those cases, however, I want to know the wholesale price going in so that I am aware of how much of my money is at increased risk from the start.
Filter #2: Am I Investing With Positive Leverage?
Use of leverage (debt) is an integral strategy for many real estate investors, but my observation is that misuse of leverage is the number one reason investors lose money. Most of us have an intuition to buy deals at low prices, but then we take crazy risks with the terms of our debt. I have some negative cash flow “scars” to prove this from my own deals.
Investing with debt should be treated like carrying a loaded gun. When my dad took me bird hunting as a little boy, he wisely taught me that a gun used carefully is a blessing, but a gun used carelessly can be a nightmare.
How do we treat leverage carefully? To start, make sure it’s positive leverage.
I made a 10-minute Youtube video on positive leverage, which basically means that the net income from your rental property is greater than the cost of your financing. In other words:
NET RENTAL INCOME
– FINANCING COST
= POSITIVE NUMBER
I invest in a lower-priced market than, for example, California or big cities. I have heard the complaint that in high-priced markets, positive leverage is nearly impossible.
My answer is that it’s not impossible. If you own a property free and clear, it will usually cash flow, won’t it? Or you can increase your down payment until you do have positive leverage.
In any market, leverage won’t make a bad deal become good. It can make a good deal even better. And it can also make a bad deal even worse. So if you find a good deal in any market and you don’t have the capital to buy it with positive leverage, it’s just a matter of finding the right money partners to invest with you.
If positive leverage seems difficult with traditional banking sources, you can also use creative purchase strategies like lease options, options, and seller-carry-back financing. I have found it much easier to get positive leverage with these sources than with bank loans.
Filter #3: Can I Conservatively Handle Balloon Payments?
This filter is also related to leverage. Along with using negative leverage, the other fatal debt strategy is to have balloon payments due that you can not conservatively handle.
Balloon payments occur when your loan has a maturity date before it is completely amortized. For example, you could amortize your loan over 30 years and your lender could require you to pay the outstanding balance at the end of year 5. By the way, this is the norm with commercial loans.
I don't like balloons. I'd prefer to have every loan fully amortize. Especially if you personally guarantee the loan, your home and your personal assets could be at risk if the balloon pops and you can't pay it off.
But, if I do agree to a balloon, here are my filter questions. I need to have a “yes” to one of these questions before I move forward:
- Is the loan balance low enough today that I could pay it off by selling at a wholesale price? (see Filter #1)
- Do I have enough cash reserves to pay the difference between the wholesale price and the loan balance?
If the answer is no to both, it means I need to borrow less money and/or get a money partner who does have the cash reserves.
This filter led me and my business partner to bring in capital partners early in our career in order to cover our worst case scenario. The worst never occurred, thankfully. We could say that we gave away profits needlessly, but it helped us sleep at night and invest with more confidence.
Zero Risk Investing?
In the world of real estate investing, there will always be some risk. Even with these margin of safety filters, I know I have made assumptions and taken risks that haven’t been addressed.
The key for me has been reducing enough risk so that I can sleep at night. From there, I can energetically and courageously take the next step forward by purchasing another property. I think that is the spirit of Warren Buffett’s rule, “Don’t lose money.”
Like me, you are bound to make mistakes — and maybe even lose money at some point. But if you keep your mistakes small and if you proactively work to quickly correct them, you can still come out intact in the end.
That’s what I love about our game of real estate. The risk equation can’t calculate the most important wildcard: YOU. Your energy, your enthusiasm, your creativity, your problem-solving ability and your relationships all contribute towards mitigating problems and reducing risks.
So good luck with your next real estate purchase. Keep a margin of safety in mind as you decide to buy (or maybe not).
How do you weigh risk and reward? What are your deciding factors or filters to do a deal or not to?
I’d love to hear your comments below.