How to Make Millions by Escaping Mr. Market’s Devious Spell

This post is the 6^th in a series that Bryan Taylor, John Jacobus, and I affectionately call “Warren Buffett is my Real Estate Mentor.” We hope his timeless wisdom impacts you like it has us.

Have You Ever Been Under a Spell?

One of the definitions of a spell is: An ability to control or influence people as though one has magical power over them.

Most of us haven’t. Or at least, we don’t know we have. (That’s the problem with spells. The person under one is usually the last to know. Dang it.)

But we all know others who have.

Like your husband who sits spellbound every Sunday afternoon all fall watching his favorite eleven NFL teams.

Or Frodo Baggins in the epic final scene at Mount Doom when it seemed like Middle Earth would be cast into darkness for another age. (They could have done that whole movie in about 17 minutes if the eagles would have just flown the ring from the Shire and dropped it into the lava river. That would have saved a ton on their $281 million production budget I’m thinking.)

Warren Buffett says that almost all investors are under a spell. And after reading his commentary, I realize that I’ve been under a spell for a lot of my investing career.

It’s the spell cast by Mr. Market.

From Buffett’s 1987 Berkshire Hathaway Annual Letter:

“Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren’t certain that you understand and can value your business far better than Mr. Market, you don’t belong in the game.”

Well that sounds harsh. Really Warren? I don’t belong in the game?

Yes.

Buffett understands that markets consist of highly emotional participants whose perspectives on the value of assets can swing wildly based on recent positive or negative news, irrespective of the underlying fundamentals. In his mind, the purpose of the market is to SERVE investors, not to GUIDE investors.

What Does Buffett Mean by This?

I love this perspective, and though it seems obvious now, I don’t think I ever thought of it just this way. (And I’m sure I never called the market “Mister.”)

Buffett encourages investors to buy assets when they’re selling at discounts to their intrinsic value. A disconnect between price and value can work in an investor’s favor when other market participants are overly pessimistic. Investors should be most active with their acquisition activity when pessimism is rampant.
In times of optimism, market participants tend to bid up prices to levels that exceed underlying asset values. This is when investors should exercise extreme caution, resist the temptation to follow the crowd, and avoid overpaying for assets. The current real estate market cycle is clearly on the optimistic side. Investors should adjust their behavior accordingly.
Warren encourages investors to remain aware of the behavior and emotional state of other market participants. To him, investors can create an advantage by adjusting their behavior to seize opportunities to buy undervalued assets when others are pessimistic. Similarly, he encourages investors to avoid activity when prices become inflated as a result of others’ optimism.
Buffett encourages investors to notice cues from other market participants and behave in ways that are contrary to the crowd. In his mind, the fact that others are buying with reckless abandon should be a signal to curb behavior and exercise caution.

I already suspected it, but I’m pretty sure Warren’s mama told him, “If everyone else is jumping off a bridge, does that mean you should?”

So, How Does This Apply to Real Estate?

Investment real estate markets are cyclical and are driven by economic activity, availability of credit, and investor outlook. At the top of the cycle, unbridled optimism leads investors to ignore warning signs and make unrealistic projections about the future. This leads to inflated prices and creates a contagious feeling among investors who fear sitting on the sidelines in fear of missing out on returns.
Many investors decide to enter the real estate market at the wrong time (i.e., at the top of the cycle when euphoria is at its peak). Unfortunately, when optimism is extreme, value is difficult to find. Similarly, even seasoned investors are influenced by the optimism of others and take undue risk during times of heightened optimism due to short memories and the emotional pull of the market.
Although it’s hardest to exercise caution when seemingly everyone is on a buying binge, it’s often best to ignore the crowd. Similarly, while it’s very difficult to take action at the depths of the market cycle, unbelievable deals can be found during this period. Some of the world’s legendary real estate investors have built substantial wealth buying real estate at fire sale prices when other market participants are highly pessimistic (e.g., Sam Zell, Conrad Hilton, etc.).
Contrast today’s market to the market in 2008-09. It’s difficult to find value in today’s market despite the fact that many seem very upbeat about the prospects of the industry. Yet great deals were abundant in 2008-09 despite the fact that many were scared to take action due to financial wounds incurred during the financial crisis.
Compressed cap rates, “hard” earnest money deposits requested on day one of due diligence, and the abundance of capital chasing fewer deals are signals that greed is the flavor of the day in the multifamily market and elsewhere. In light of the diminished prudence with which others are conducting themselves in the multifamily market, Mr. Buffett may suggest that now is a time to exercise greater prudence with your own affairs.

The Rubber Meets the Road

I said this was particularly applicable to me, and I’m excited to share it with you. I’ve had my share of success and mistakes in this arena. Like…

When the world was chasing waterfront properties, my partner and I jumped on the bandwagon. We got in about the middle – not too early or too late. We made a lot of money buying overgrown waterfront lots at Smith Mountain Lake starting in 2004. When Fortune magazine’s cover said, “The Real Estate Bubble is about to burst,” we eagerly read the article. We believed it (generally). But we had a pipeline of great deals, so we bought a few more. Then the market turned. Which led to my famous (in my own mind) story of going $2.5 million into debt in the midst of the recession. You can read how I got out here.
In the midst of the Bakken oil boom in 2011, we saw a huge opportunity to build high-quality multifamily, hotels, and “man camps” in northwest North Dakota. We got in fairly early. We built the nicest place in town, ran it profitably for years, then sold if for a great profit. If a little “greed” worked, more would be better, right? We went on to build a very large, very nice hotel. It was said to be the nicest in North Dakota. That’s great, but when oil prices did the unthinkable and dropped from the $90s to the $30s, so did oil exploration and business travel. (That was more like a bad idea in any economy honestly. Depending on oil prices for your success is speculating, not investing.)

A Quick Test

There are probably many ways to test to see if you may be falling under Mr. Market’s spell. Here are a few sample questions to ask yourself and your trusted advisors. You should certainly come up with your own to fit your situation.

You’re about to buy a multifamily asset. If the BiggerPockets forums and news headlines light up with people saying that it’s time to sell multifamily now, would this change your mind?
Are you counting on appreciation and the potential of refinance to make your deal work? Or does it work well as a cash flowing deal now, with or without appreciation?
If it was 2009 again, and there were plentiful deals to be had for 40 cents on the dollar but no one else wanted in, would you consider buying?
In the midst of a recession do you think like many: this is the big one, and the market won’t ever go back to normal?
Similarly, in the midst of a bull market, do you think this is the new normal. Cap rates will continue to compress and this buying binge has no end in sight. I want in at almost any cost?

And remember, before you buzz through a list of questions like this, the words of the famous physicist, Richard Feynman:

“The first principle is that you must not fool yourself, and you are the easiest person to fool.”

Getting Personal

In my last post, I told the story of how Warren Buffett truly lives by his own teaching. He bought financial companies when virtually no one else would touch them. I hope that you will follow in his footsteps. I plan to.

I really do believe that I’ve learned my lesson. My team and I are not overpaying for apartments. There are plenty of others doing that, and I hope you’re not among them. We’re still bidding on apartments, by the way. Just not willing to consciously overpay.

And I didn’t chase the speculative crypto market. Though when my close friend, a 60-something doctor, made millions under his Millennial son’s guidance, I must say I was tempted. And a little jealous.

And like I’ve been talking about for a few months, our team is currently investing in a less sexy asset class. And we’re really excited about it!

And after that one, we may even look at mobile home parks. As you may know, Buffett and Zell were way ahead of us on manufactured housing, so it could be a good bet.

If it’s not too late that is.

By the way, if you hear about them selling, please let me know. I’d rather be under their spell than that of Mr. Market.

So what about you? What are you doing to protect yourself from being under Mr. Market’s spell?

Or are you ok just going with the crowd and hoping it works out? Share below!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.