Learn from Warren Buffett Failures & Create a Moat Around Your Business
This is the fourth article in the Warren Buffett Real Estate Mentoring series. John Jacobus, Bryan Taylor, and I plan to turn this series into a book in 2019, and BiggerPockets readers are getting an early peek at some of its contents.
Warren Buffett famously said, “A truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital.”
What is A Moat, Anyway?
In medieval times, a moat was a protective water barrier that kept attackers from seizing control of a castle.
In the business world, the “castle” is the business or productive asset. The “moat” is the competitive advantage that serves as a protective barrier around the business to preserve its lifespan and keep competitors (attackers) at bay. The moat is also the mechanism that preserves economic profits.
Businesses with deep-and-wide moats around them have the greatest protection from threats and are typically the most durable.
Buffett has been doing this fairly well since 1964. If you invested $1,000 in Berkshire Hathaway that year, it would be worth over $15,000,000 today. His 19 percent average annual compounded returns over 54 years is not bad I guess.
Buffett’s First Failure
Did you know that Buffett’s conviction about creating a moat probably started with his worst investment? A twenty-something-year-old Buffett lost 100 percent of his investment, plus thousands of hours of sweat and anguish, when he bought an Omaha filling station with a friend in the early 1950s.
Though they did everything right, Buffet and his buddy helplessly watched cars stream into the Texaco station across the street while they rearranged wiper blades and swept the floors.
They had underestimated the power of the relational moat, built over decades by the personable Texaco station owner across the street. Those were the good ole’ days when the station owner personally pumped customers’ gas — offering up a few jokes and a clean windshield along the way.
Buffett and his friend eventually closed up shop, but not before young Warren had learned valuable lessons that would eventually make him tens of billions of dollars.
What Does Warren Have to Say About Moats?
From the annual meeting in 2000:
“So we think in terms of that moat, and the ability to keep its width and its impossibility of being crossed, as the primary criterion of a great business. And we tell our managers we want the moat widened every year. That doesn’t necessarily mean the profit will be more this year than it was last year, because it won’t be sometimes. However, if the moat is widened every year, the business will do very well. When we see a moat that’s tenuous in any way — it’s just too risky. We don’t know how to evaluate that. And, therefore, we leave it alone. We think that all of our businesses — or virtually all of our businesses — have pretty darned good moats.”
From a lecture to MBA students at The University of Florida School of Business in 1998:
“Managers of the businesses we run, I’ve got one message to them, which is to widen the moat. And we want to throw crocodiles and sharks and everything else, gators, I guess, into the moat to keep away competitors. And that comes about through service. It comes about through quality of product. It comes about through cost. It comes about sometimes through patents. It comes about through real estate location.”
From Berkshire Hathaway’s Annual Meeting in 1999:
“No formula in finance tells you that the moat is 28 feet wide and 16 feet deep. That’s what drives the academics crazy. They can compute standard deviations and betas, but they can’t understand moats. Maybe I’m being too hard on the academics.”
From Berkshire’s Annual Meeting in 1995:
“It is all a matter of trying to find businesses with wide moats protecting a large castle occupied by an honest lord. Moats might be a natural franchise, brand loyalty, or being a low-cost producer. In a capitalistic society, all moats are subject to attack: If you have a good castle, others will want it. What we want to figure out is what keeps the castle standing and how smart is the lord.”
Now, let’s translate this medieval-moat talk into real business terms we can all understand.
Economic Moats Can Take the Following Forms in the Business World:
Switching costs are high when customers are reluctant to stop using a business’ product or service, because doing so would be too troublesome and/or cause disruption to their operations. When this situation occurs, the business can raise the price of their products or services without risk of losing customer. Buffett’s investment in Precision Castparts demonstrated his high switching cost strategy.
Brands, patents, trademarks, and regulatory barriers can prevent competitors from duplicating a business’ products or services. Because the products and services are protected from copycats, it can charge a premium for them and earn excess profits. Buffett famously drinks Cherry Coke, and his long-time investment in Coke shows that he knows the power of intangibles.
Businesses that have structural cost advantages can undercut competition while earning similar margins. Buffett owns GEICO, which is well known for low-cost insurance.
The value of a business’ services grows for new and existing customers as more people use the service. As the service increases in value to its users, the business can charge more for the service and generate excess profits. Buffett has held shares in American Express for many decades, and the compounding result shows the power of network effects.
So How Would Buffett Build or Widen A Moat Around A Rental Real Estate Business?
I'm going to translate some of these truths to real estate by using several examples of how my company is implementing these lessons in our latest multifamily acquisition — a 125-unit townhome community in Lexington, Kentucky.
Economic Moat: High Switching Costs
Raise your tenant’s cost of moving to another property:
- Offer self-storage facilities that cause residents of your rental property to accumulate more personal belongings and establish a more permanent life in your property. When contemplating a move to another property, in light of rent increases or other circumstances, they may think twice about leaving due to the hassle of having to move all of their belongings and the disruption this would cause in their lives.
I just heard about a Denver single-family home entrepreneur who buys (or builds out) rental homes with large storage spaces in each one. His tenants tend to accumulate a lot more stuff over the years, and when considering a new rental, find it very hard to find one with enough space to store their stuff.
- Invest in self-storage facilities. Consider this: When you raise rent by 6 percent on a $1,000 rental home, you may motivate a tenant to move. But when you raise rent by 6 percent on a $100 self storage unit, the tenant has to ask: “Is it really worth taking my Saturday, a friend’s time, and a U-Haul rental to load and cart my stuff down the street to save $6 per month?” Most self storage tenants only expect to stay “a few more months” anyway, though statistics say they typically stay for years. (If you want to discuss why I am personally investing in self storage in 2018, message me on BP.)
- Offer amenities and services that make your rental property irresistible to your residents so that they can’t imagine moving to another community because of the disruption they would experience in their daily routine.
- Create a unique sense of community and provide opportunities for your residents to develop meaningful relationships, such that they would experience significant loss if they decided to move away from the community.
At my townhomes in Lexington, Kentucky, my team is working to establish a connected community to live in to assure our residents want to stay. We don’t know of another local community with the level of fun events and opportunities for residents to connect. We are building a place where units are homes, and homes are connected as a community. We are giving residents a context to generally care about, and care for, one another.
This “love your neighbor” approach is statistically proven to improve online reviews, increase renewals, increase resident referrals, and raise profits. We love all of that. But we are doing it because it is the right thing to do. Building a moat around our multifamily asset is a wonderful side benefit.
Economic Moat: Cost Advantage
Exploit opportunities to reduce your expenses, such that you would be able to rent your units at rates below your competition while still earning sufficient economic profits:
- Pursue energy efficiency programs to reduce water and electricity costs. Freddie Mac offers a compelling low-cost financing program to borrowers who employ "green" practices at their properties.
The installation of water and gas meters helped us meet our Freddie Mac Green Loan qualifications when closing on a recent apartment acquisition. This one decision saved us 20 basis points (0.20 percent) on our loan interest rate which will save us over $12,000 annually in interest on a $6.3 million loan.
We have been amazed to see how much water was actually being wasted in the community. The system is quite responsive and automatically notifies our management team by email anytime water usage for a specific unit goes over a preset amount in one hour. It also sends 24-hour summary reports on the full community and each unit. The maintenance team is able to use this information to attack leaks and water left running on a “real time” basis. There are many instances where a single toilet leaks several thousand gallons a day. We pay those bills now, but someday the tenant will. These savings will benefit everyone, including the environment. The chart below shows what happened in unit 129 one day in late March.
- Review opportunities to make your rental units “tenant proof” by equipping your units with more durable materials (such as vinyl flooring instead of carpet) and eliminating items from your property that demand ongoing maintenance (e.g., cheap venetian blinds).
In our Kentucky townhome community, we were happy to uncover beautiful hardwood floors under the soiled carpet and padding. We are spending about $1,300 per unit to beautifully refinish some of these floors, but the increase in rent ($50 per month = 46 percent ROI) and the savings in carpet costs for years to come are a big payoff. Plus, the real hardwood floors are a nice marketing draw for the community. Check out this photo of a freshly refinished bedroom.
- If you are handy and can deliver high quality maintenance work or if you enjoy self-managing your rental properties, consider taking on some of this work yourself rather than paying a professional to perform the service.
Economic Moat: Intangible Assets
Acquire the right property in the right location. Run your rental properties in a way that sets you apart from others in your market. Establish a brand that stands for something meaningful in your market and helps prospective residents reduce their search time, or creates a sense of trust, or establishes a certain quality expectation in their minds:
- Explore ways to differentiate your rental property from others in the market. Offer unusually appealing amenities like chef-guided cooking classes (who doesn’t want to learn to cook semi-boneless ham?), on-site athletic trainers, dog parks, etc. Become known in the market for offering something special in your community.
In our community, we realized that almost 50 percent of residents had pets. But like the other apartment assets in the area, there was no dog park. By building a “Bark Park,” we set ourselves apart from the competition. (And it made it harder for residents who had snuck in dogs without paying pet fees to keep hiding.)
- If you own multiple properties in a market, establish consistency in the way you market your units and serve your residents. Your brand should be known for something specific (e.g. high-quality service, good location, exceptional amenities, great value, etc.) in the market. This way, prospective residents have something established in their minds when they see your brand in various advertisements.
- Identify ways to provide exceptional service to your residents. Do you provide on-site maintenance staff with a specific service level guarantee to residents and/or response time? Do you allow residents to modify certain aspects of their rental unit to make it feel more personal? Do you publish a community newsletter that provides value to your residents?
- Acquire properties that are in exceptional locations and are hard to replicate. Understand what is unique about your property location and promote it in your market in a way that makes it irresistible to prospective residents who value those qualities.
We recently considered buying an asset in Chattanooga. When doing the 1-3-5 analysis (driving all of the streets within 1-, 3-, and 5-mile rings around the asset), we noticed that there was a lot of green space – undeveloped land – between the subject apartments and the bulk of the city’s population. Not a good sign.
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By contrast, when we looked at Lexington, Kentucky, we discovered a wonderful moat. Lexington has gone to great lengths to promote tourism. They’ve done this by protecting the many horse farms that surround the city. By establishing an “urban service growth boundary,” they have limited new development to its current footprint.
A study shows that Lexington has a demand for over 6,000 new apartment units within eight years. But there is virtually no place to build them. Lexington has built a moat around itself, and the owners of rental real estate are the beneficiaries. This is one of the reasons we were thrilled to buy apartments there.
On A Personal Note…
Now that I’ve gotten you pondering castles and moats, think about how you can erect moats in your personal life as well. We were created for relationships, and it is tragic to see someone work for decades to build a great business at the cost of his or her family.
Buffett famously struggled in this arena, but he had a beautiful wake-up call after the death of his long-estranged wife. Buffett later said, “Basically, when you get to my age, you’ll really measure your success in life by how many of the people you want to have love you actually do love you.”
I sat and grieved with a close friend the other day. His job has forced him to travel — a lot. And he had not taken the time to cherish and care for his wife like he knew he should have. He was reluctant to seek counseling, and she finally quit asking.
His wife unexpectedly showed up at their home with some new friends and a moving van. He got the papers later. He will now be faced with the years of pain and regret from both of their choices. My friend had not built a moat around his marriage.
Real estate investing gives us opportunities to build passive income that will allow us to spend more of our most precious commodity (time) doing what we were made to do.
Use your time wisely and build moats in your business and in the most important areas of your life. Because time is one resource that is guaranteed to run out.
What about you? How are you erecting moats in your business and life?
There are hundreds of ways to do so. Tell me what you’re doing or planning in the comments below!