This post is the 7th<\/sup> in a series<\/a> that Bryan Taylor<\/a>, John Jacobus<\/a>, and I affectionately call \u201cWarren Buffett is My Real Estate Mentor.\u201d We hope Buffett\u2019s wisdom impacts you as it has us.<\/em><\/p><\/blockquote>\n
What Is the Margin of Safety?<\/h2>\n
The margin of safety is a principle of investing in which an investor only purchases assets when their purchase price is significantly below their estimate of intrinsic value.<\/p>\n
In other words, when the purchase price of an asset is significantly below your estimation of its intrinsic value, the difference is the margin of safety. Because investors may set a margin of safety in accordance with their own risk preferences, buying assets when this difference is present allows an investment to be made with lower downside risk. Thus sayeth Investopedia<\/a>.<\/p>\n
Related:<\/strong> What Interviewing 100+ Investors on Failure Taught Me About Losing Money<\/a><\/em><\/p>\n
What Does Warren Buffett Think?<\/h2>\n
\u201cWell, if you\u2019re driving a truck across a bridge that holds\u2014it says it holds 10,000 pounds\u2014and you\u2019ve got a 9,800-pound vehicle, you know, if the bridge is about six inches above the crevice that it covers, you may feel OK. But if it\u2019s, you know, over the Grand Canyon, you may feel you want a little larger margin of safety, in terms of only driving a 4,000-pound truck, or something, across. So it depends on the nature of the underlying risk.\u201d \u2014Berkshire Hathaway Annual Meeting 1997<\/a><\/p><\/blockquote>\n
This really did remind me of engineering school. When designing drilling rigs or bridges, we had to design all of the components to withstand all of the forces that could be involved. When all the calculations were done, we had to slap on a margin of safety or safety factor. If the safety factor was 3.2, we had to make it 220% stronger than it \u201cneeded\u201d to be. (That would mean a margin of safety of 2.2, but that is getting technical.)<\/p>\n
To a 19-year-old punk, this seemed like a needless waste. \u201cWait\u2026 the biggest semi-truck allowed on this road weighs 80,000 pounds. But we have to design the bridge to withstand 256,000 pounds? Isn\u2019t that a huge waste?\u201d<\/em><\/p>\n
I didn\u2019t know that one in four U.S. bridges failed in the 1800s. This makes a lot of sense to me now.<\/p>\n
But I hadn\u2019t thought of this engineering term when making investments\u2014the widely-read Buffett connected the dots for me.<\/p>\n
The margin of safety is a key concept for us to understand when making an investment in something that has inherent unknowns. Which is every investment I can think of. The margin of safety is a risk management concept that forces us to think about our purchase price relative to our estimate of intrinsic value.<\/p>\n
Using non-financial examples, like Buffett\u2019s bridge, really drives the point home for me. Having a margin of safety is an intuitive concept when deciding to cross a bridge (unless you\u2019re a daredevil) but can be more difficult to \u201csee\u201d when studying, say, a pro forma<\/a> analysis of a potential investment.<\/p>\n
Real Estate Investment and the Margin of Safety<\/h2>\n
Real estate has numerous unknowns. Your floating debt may change based on unpredictable factors. Your local economy may suffer layoffs. Your property manager may make bad decisions. Your turnaround plan may suffer from unforeseen tariffs on raw materials. The list goes on.<\/p>\n
The challenge is to not focus on accurately calculating a margin of safety for all of these unknowns. You just can\u2019t do this effectively. (Check out this article<\/a> on becoming a billionaire by being approximately right on a few<\/em> key variables.)<\/p>\n
The key is to purchase real estate at a price that allows for a safety net in the event that some random combination of these unknown events occur.
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\nRelated:<\/strong> 3 Ways to Reduce Risk in Your Real Estate Portfolio<\/a><\/em><\/p>\nSome Practical Examples<\/h2>\n
Ensuring that your investment property has adequate debt service coverage (DSC)<\/a> is a great example of why building in a margin of safety is crucial. You must ensure that your cash flow is sufficient to cover your debt obligations.<\/p>\n
But should you simply make sure that it covers it by just 100%? Or should you make sure that you cover debt service by more than 100%?<\/p>\n
You know the answer. You don\u2019t want to risk some unknown occurrence that would increase your operating expenses and leave you unable to pay your mortgage. That\u2019s a good way to learn a very hard lesson in real estate.<\/p>\n
You\u2019ll be glad to know your banker won\u2019t allow this to happen. They insist on a margin of safety of at least 25% (debt service coverage ratio of 1.25x\u2014you should aim for much higher than this).<\/p>\n
Another great example is forecasting occupancy and rent rates on multifamily properties. You can easily find data that show average occupancy and rent rates for comparable properties. When you do, should you simply use those averages for your forecasting purposes?<\/p>\n
No.<\/p>\n
When applying a margin of safety, you\u2019ll want to forecast your occupancy below market averages\u2014and the same for rent rates. This is often described as being conservative, but really you\u2019re adding a margin of safety in the event your property suffers low occupancy or your forecasted rent rates are not happening. Your investors will thank you, trust me.<\/p>\n
Why I\u2019m Not Investing in Multifamily Right Now<\/h2>\n
As the author of an arrogantly titled book on multifamily investing, I\u2019m frequently asked why I\u2019m not (or why I\u2019m rarely) investing in multifamily right now. And why our company has expanded to self-storage and mobile home parks. It\u2019s a fair question that deserves an answer.<\/p>\n
My response involves the margin of safety. As I\u2019ve said in several BiggerPockets posts<\/a>, most anyone in the multifamily world knows prices are crazy overheated right now. Yet there are still plenty of eager buyers, seemingly eager to overpay. It is obviously continuing to drive prices higher. And I have some theories<\/a> on why this is happening.<\/p>\n
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