Living on the Edge - how to invest with a safety net

“I’m not worried about making any monthly profit on my properties anymore, in fact, I’m ok with it losing a little money because I’m in this for the appreciation.”

I recently heard these words on a real estate investing podcast and my jaw immediately hit the floor. WHAT???

The idea of investing purely for appreciation is extremely risky, but first, let me explain what real estate appreciation is. Appreciation is the increase in a property’s value over time. How much a property appreciates each year depends on the local real estate market and any improvements to the home. A property’s appreciation is calculated based on the fair market value of comparable property’s for sale in the neighborhood.

A simple example is if you buy a house for $100,000 cash, and the local market appreciates 4% in a year, the house is now potentially worth $104,000. Potentially is the keyword here because you don’t get to benefit from appreciation until after you sell.

Some coastal cities are seeing home values more than double since 2010 making the market conditions during this past decade the most favorable in a generation! However, people seem to be forgetting that those same properties lose over 50 percent of their value in the last downturn. Because no one can predict what the market is going to do, people who invest based on market appreciation are ignoring one of the most crucial concepts of investing - the safety margin.

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. 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. (1)

The margin of safety was made famous by Warren Buffet and Charlie Munger and their idea that it is better to be approximately right than precisely wrong.

“Well, if you’re driving a truck across a bridge that holds—it says it holds 10,000 pounds—and you’ve 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’s, 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.” — Berkshire Hathaway Annual Meeting 1997

Here are a few ways you can apply a safety margin to real estate investing:

• Plan on having a higher than the market rate of vacancies
• Plan on rents being average not at the top of the market
• Buy a property with enough saved in an emergency fund to cover two major capital expenditures (new furnace or major water mitigation project)

Yes, you might miss out on more properties because of the safety margin but if you’re investing for the long-term you will be dramatically reducing the chance of losing money and increasing the amount of fun you’ll have investing in real estate, too.

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(1) Chen, James. “Margin of Safety.” Investopedia, Investopedia, 25 June 2019, www.investopedia.com/terms/m/marginofsafety.asp.