Why Your Real Estate Portfolio Is Not Safe

OK, class. Let’s take a pop quiz. When you hear the word "margin," do you think of...

1. the distance between the edge of your paper and where you start writing?
2. the profit on your latest amazing house flip?
3. the edge or border of something (like the margin of the Atlantic Ocean)?
4. the difference between the value of your day trading account and the loan from the broker?
5. that gristly (but oh so tasty) little edge between the meat and the bone on a semi-boneless ham?
6. one of Warren Buffett’s key ingredients to his wild success as an investor?

I’m joined by my friends John Jacobus and Bryan Taylor to pen a series of articles on one of the world’s all-time great investors, Warren Buffett. My last two posts in this series talked about Buffett’s margin of safety concept and how he applies it to his investing decisions. I want to round out that important discussion by considering what his ever-blunt partner, Charlie Munger, has to say about this topic. At the 2007 Berkshire Hathaway Annual Meeting, Munger said, "Margin of safety means getting more value than you’re paying. There are many ways to get value. It’s high school algebra; if you can’t do this, then don’t invest."

Margin of Safety According to Charlie Munger

Margin of safety is indeed a simple concept. If you find that your analysis becomes overly complex when applying it, you should rethink the intent of this factor in the first place. Like I discussed in a prior post, it should just be a matter of multiplying by a ratio or adding a factor. Here's an example of how to apply the debt service coverage ratio (DSCR or DCR). If you need to clear $10,000 per month to pay your multifamily mortgage, then your lender will insist that you reasonably forecast at least $12,500. This is a DSCR of 1.25 or a 25 percent debt coverage margin of safety. Though this is the minimum standard, I suggest that you add a margin of safety on top of the bank and go for a ratio of 1.35 or more. And if you can get to 1.5+, even better. _ Related:  _How to Use a Margin of Safety to Avoid Financial Disaster (The Buffett Series)

What Does This Mean for Real Estate Investors?

Keep it simple, stupid. (I’m talking to myself, not you of course. I would never call you stupid unless you lived at my house. Yes, that was another lame joke.) When evaluating a real estate opportunity, keep your analysis simple, make your estimates conservative, and then apply a margin of safety to your numbers. By , you avoid the sirens of endlessly complex forecasting based on factors that are way too hard to predict accurately. Real estate investments are inherently not that complex. You know what you will pay for the asset, you understand how the asset can produce income, and you can reasonably understand the costs associated with owning this asset. With simple math and the margin of safety, you will spare yourself the pain caused by overpaying. And if you’re new to this, trust me, it’s a lot of pain. _ Related:  _Understanding Debt Service Coverage Ratio

Where to Look for Opportunities to Buy with a Margin of Safety

As I’ve discussed, I’m finding a hard time getting a margin of safety in multifamily investing these days. About 93 percent of 50-plus-unit multifamily assets are owned by operators with multiple assets. Most of these are professional or institutional operators. They know what they’re doing. They’ve typically done the upgrades and other value-adds, optimized the marketing, and are riding the current overheated multifamily wave to huge profits. Good for them. Bad for us buyers and investors. But I’ve discovered a few other asset classes that have some “hidden” opportunities to buy right—that is, with a margin of safety. While 93 percent of large multifamily are controlled by pros, about 65 to 75 percent or more of self-storage and over 90 percent of mobile home park assets in the U.S. are owned by small operators. Many are mom and pops. And a huge percentage of these are run like a passive investment. We’ve all dreamed of passive investments that produce mailbox money, and these operators have got it. They’ve found their Xanadu. Good for them. Many of them had some land outside of town and constructed self-storage facilities or a mobile home park back in the day. Or they bought (or inherited) one decades ago. Both of these asset classes can provide easy money to sloppy operators. Unlike multifamily or senior living, they can be run semi-passively and still make a profit. These operators seemingly live by the mantra “if you build it, they will come.” And it’s worked out fine for them. Many of these owners are ready to exit and ride off into the sunset. Others are on the path of progress. Some have extra land, underutilized road frontage, or a nice hill that would look good with a cell tower on it. Tons of opportunities exist that are just waiting for the right operators. One of these could be your opportunity! By seeing what these assets could potentially produce, an experienced operator can pay a more than fair price to the seller and still have a built-in margin of safety. For example, my firm is currently investing with an operator who has decades of collective experience in buying these types of deals (i.e., self-storage assets that are doing “just fine” in their semi-passive state, but could be extremely profitable if run by a pro). This operator forces appreciation and adds profit through management efficiencies, expansion, and a variety of operating and marketing techniques.

Disclaimer: I am not projecting the following returns for this asset inside my growth fund. We are targeting 19 percent total annual returns for the fund over the course of seven years. Some of the numbers below are theoretical in nature and cannot be accurately projected in advance.

Last month we invested in an asset in the Carolinas. My business partner was on the ground there for two days recently, and we are excited about seeing our operator/partner acquire it and transform it into a profit machine. Our investors are excited, too.

Here are a few highlights:

• It has extra land with road frontage along a major four-lane highway. (It’s currently on a side street behind the highway. Visibility will go from poor to awesome.) The current small scrub bushes and trees will be replaced with a beautiful new showroom and signage.
• The showroom will provide extra income in the form of boxes, tape, scissors, and locks for sale.
• The operator will partner with U-Haul, which could add a few thousand per month to the bottom line. It will potentially have the side benefit of increasing occupancy 3 to 5 percent, as well.
• The operator will use some of the extra land to build a beautiful climate-controlled building, which will also increase revenue and profits.
• The facility and all its competitors are nearly completely full, and the current operator’s rents are about 25 percent below average. Rents should be able to be increased by 20 to 25 percent with little effort, with the opportunity for additional increases after upgrading the frontage and signage and adding a showroom.
• This operator has a great track record of selling his stabilized assets to institutional buyers like REITs. He may be able to sell at a compressed cap rate, which would result in a premium price.

Potential Profits and Value From Upgrades

Let’s look at the potential of a few of these items on profitability:

• Increasing rents by up to 25 percent will increase profits substantially—perhaps 30 percent—since costs won’t necessarily increase as much. The effect on the value of the asset is projected to be more than 30 percent (Income / Cap Rate = Value). But the effect on equity for investors is much higher due to leverage. With an LTV of about 66 percent, the impact to equity appreciation is [30% / (1 - 0.66) = 88%+]. (This means there's potential of an 88% equity increase from just raising rates!)
• This point is more theoretical and generalized, but if he can buy at a 7 percent cap rate and sell at a 5.4 percent cap rate, which is typical, this is a 22.9 percent increase in value in itself. (Dividing the same income by .07 versus .054 will result in a 22.9 percent higher sales price.) When multiplied by the leverage effect [22.9% / (1 - .66)], this is another 67.4 percent increase in the value of the equity.
• There is also increased income from point-of-sale items, U-Haul, marketing improvements, and more. Assume increased net operating income of 15 percent from all of this. This impacts the asset value by 15 percent and the equity value by [15% / (1 - .66) = 44%+].

There are quite a few more ways this operator has successfully increased income and value in past projects. I didn’t even count the value of adding a large new climate-controlled building, for example. The combined total asset appreciation from the three changes documented above is arguably 68 percent (30% + 23% + 15%). When applying leverage, this arguably results in an increased equity value of 200 percent.

68% / (1 - .66) = 68% / 0.34 = 200%

If this takes five years, that’s equity appreciation of 40 percent annually. I know this sounds ridiculous, but I’ve seen this type of pattern repeated by this operator and others for years. However, it should be noted that market conditions in 2010 through 2018 have been the most favorable in a generation (or maybe ever). This has led to some of these outlandish returns. All operators and their investors have been the beneficiaries and one day the market will correct. The opportunity to buy right, force appreciation, and operate efficiently all provide a margin of safety for this eventuality.

Applying the Margin of Safety

Will I count on this type of performance to make the deal work? Or promise this to investors? Not on your life. We’d be better to assume this project hits half its goals in this timeframe. Slashing our asset appreciation in half from 68 to 34 percent results in an equity appreciation adjustment from 200 to 100 percent—about 20 percent annually over five years. Not too shabby. Even then, I would cut that by a margin of safety in making investor projections. As you can see, the cumulative effect of all of these value-adds translates to an asset that has a much higher value to the buyer than it did for the seller. This provides a great margin of safety for the right buyer that has located the right asset at a fair price. Does this mean the buyer should willingly overpay? No. But with today's inflated prices, it is great to have a strategy that allows for a purchase like this. _ _Don't get me wrong, this is not free or easy money. This is the result of years of experience, a great operation, relationships with the right sellers and buyers, and a lot of hard work. Regardless, the payoffs to the operator and our investors are a beautiful thing.  This is why my firm is spending a lot of our time creating relationships with these types of operators. And our investors are investing millions in deals like this one and many more. In my self-storage example, the margin of safety is created by possessing the knowledge and having the team to operate this asset at a much higher level than it is currently. Additional safety is created by the fact that the operator is buying at a price that works for him today—even without these proposed changes. So, in summary, margin of safety does not always mean getting a deep discount on the purchase price. That is a great thing to do and can be done by catching a falling knife in times like the Fall of 2008. Margin of safety can also be created by having the knowledge to recognize the intrinsic value in a real estate asset and assembling a team to execute the creation of that higher value. Buffett has done this exact thing for decades, and he’s become the most famous investor of our time because of it. I’d like to follow in his shoes. Who's with me? Do you have any advice to add or anecdotes to share? Comment below.