Ignore This Principle and You’ll Destroy Your Real Estate Career

by | BiggerPockets.com

I admit it. I’m a recovering engineer.

Truth be told, I should never have gone to engineering school. I didn’t know myself at all. I didn’t know my strengths and weaknesses, my likes and dislikes. I didn’t know I was created to be an entrepreneur and certainly didn’t know about the power of real estate investing.

So, in my Junior year of high school, I learned that there were no degrees in parapsychology (yes, I’m embarrassed to say I’m serious). I wanted to do something adventurous, and that’s about the time I heard about petroleum engineering. So I signed up.

That was my first big career mistake.

But I shouldn’t lament. I enjoyed a rigorous education, and my (more valuable) MBA degree seemed easy by comparison (no calculus or physics!).

And I learned an important Buffettism before I’d ever heard of Warren Buffett.

I hope you already know about it, in name or in practice, but if you don’t practice it, you’re sure to come to financial ruin. It’s called the margin of safety.

This post is the 7th in a series that Bryan Taylor, John Jacobus, and I affectionately call “Warren Buffett is my Real Estate Mentor.” We hope Buffett’s wisdom impacts you as it has us.

What is the Margin of Safety?

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. Thus sayeth Investopedia.

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Related: What Interviewing 100+ Investors on Failure Taught Me About Losing Money

What Sayeth Warren Buffett?

“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

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 “needed” to be. (That would mean a margin of safety of 2.2, but that is getting technical.)

To a 19-year-old punk, this seemed like a needless waste. “Wait… 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’t that a huge waste?” (I didn’t know that one in four U.S. bridges failed in the 1800s.)

Thirty-six years later, this makes a lot of sense. But it didn’t then.

I hadn’t thought of this engineering term when making investments, but the widely-read Buffett connected the dots for me.

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.

Using non-financial examples, like Buffett’s 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’re a daredevil), but can be more difficult to “see” when studying, say, a pro forma analysis of a potential investment.

So, What Does This Mean for Real Estate Investors?

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.

The challenge is to not focus on accurately calculating a margin of safety for all of these unknowns. You just can’t do this effectively. (Check out this earlier article on becoming a billionaire by being approximately right on a few key variables.)

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 currently unknown events occur.

Related: 3 Ways to Reduce Risk in Your Real Estate Portfolio

Some Practical Examples

Ensuring that your investment property has adequate debt service coverage (DSC) is a great example why building in a margin of safety is crucial. You must ensure that your cash flow is sufficient to cover your debt obligations.

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%?

You know the answer. You don’t want to risk some unknown occurrence which would increase your operating expenses and leave you unable to pay your mortgage. That’s a good way to learn a very hard lesson in real estate.

You’ll be glad to know your banker won’t allow this to happen. They insist on a margin of safety of at least 25% (debt service coverage ratio of 1.25x—you should aim for much higher than this).

Another great example is forecasting occupancy and rent rates on multifamily properties. You can easily find data that shows average occupancy and rent rates for comparable properties. When you do, should you simply use those averages for your forecasting purposes?

No. When applying a margin of safety, you’ll want to forecast your occupancy below market averages and the same for rent rates. This is often described as being conservative, but really you’re 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.

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Why I’m Not Investing in Multifamily Right Now

As the author of an arrogantly titled book on multifamily investing, I’m frequently asked why I’m not (or why I’m rarely) investing in multifamily right now. And why our company has expanded to self-storage and mobile home parks. It’s a fair question that deserves an answer.

My response involves the margin of safety. As I’ve said in several recent BiggerPockets posts, 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. I have some theories on why this is happening, and some insightful commenters on my last post added some more. This is obviously continuing to drive prices higher.

I hope you’re not one of these overzealous buyers, but if you are, I urge you to STOP IT! My firm is still reviewing multifamily opportunities, but we believe that most of them will be on the other side of a market correction.

Correction? When?

That would require a crystal ball to predict. And those who live by a crystal ball are destined to eat ground glass.

Buffett won’t even predict the timing of these downturns. But he has learned to act appropriately at each point in the cycle. And that’s what we must do, too.

I was at a large conference in Miami two weeks ago, and one of America’s most famous multifamily syndicators challenged my thinking. He has been incredibly successful during this nearly decade-long run-up in prices, and he’s earned the right to be heard.

He said, “Don’t worry about overpaying for multifamily. Just find a great property in a great location.” He went on to explain his reasons. (I’m not naming him because I didn’t catch the exact quote, and I don’t want to make him look bad.)

My friends, my mind drifted quickly to Mr. Buffett, who has been massively successful since about the year this guy was born. Through many recessions, wars and more, Buffett has amassed one of history’s most enviable fortunes. And he’s given us his wisdom all along the way.

Would Warren Buffett ever say this? Would he say, “I’m fine with consistently overpaying for companies I buy”?

Not on your life.

Buffett clearly looks for companies that are undervalued, with latent potential that is yet unrealized. Buffett had the guts to buy financial equities when the financial markets were in a free fall in 2008. Buffett has consistently said no to buying at the top of the market.

Buffett lives by the margin of safety.

We would do well to do likewise.

What about you? How do you factor in a margin of safety when investing in real estate?

Comment below!

About Author

Paul Moore

Paul is author of The Perfect Investment - Create Enduring Wealth from the Historic Shift to Multifamily Housing, which you should probably get if you want to learn to invest in multifamily. He is a Managing Partner at Wellings Capital, a multifamily and self-storage investment firm, and hosts the How to Lose Money podcast. Paul was 2-time Finalist for MI Entrepreneur of the Year, has flipped 60 homes and 30 waterfront lots, developed a subdivision, and appeared on HGTV. Paul's firm invests heavily to fight human trafficking and rescue its victims.

38 Comments

  1. Mike McKinzie

    I try to make this very simple, if my Mortgage Payment is more than 50% of the rent, I feel my margin of safety is too thin. And while there are other factors to consider in making an investment, the bottom line is your INCOME (rent) and EXPENSES (mortgage, management, repairs, taxes, insurance, CapEx, etc…) It has been proven over and over, here on BP, that all the expenses/vacancies, OVER TIME, will be around 50%. Therefore, if your Mortgage payment is more than 50%, you are in a losing position. It may work for a while, but all of a sudden you need a new roof, a new HVAC system, a new fence, or a prolonged vacancy. I had an example in 2018. I own a great little rental in OK. Year after year, it was running 25-30 percent expenses. In 2018, my Gross Expenses surpassed my Gross Income by $13,500.00. My mortgage is 42% of the rent. Not only does it happen, it WILL happen to anyone who owns a rental for longer than 10 years. Therefore, make sure you margin of safety is where you want it to be!

    • Deanna Opgenort

      Remember is that part of your mortgage is going toward the principle, so even if you spend every dime you get in rent, you are actually doing a bit better than it might seem at first . I feel your pain though, — 2018 had $8k in repair/rehap/maintenance expenses on a property that grossed less than 10k in rent. @ $2-3k was flooring & paint that was due for a refresh due to age, $1,500 was flooring that needed to be replaced early due to pet damage, & $3.500 was repairs that were going to need to be done anyhow sensible to be addressed while the flooring was up.

      • chris schu

        “Remember is that part of your mortgage is going toward the principle, so even if you spend every dime you get in rent, you are actually doing a bit better than it might seem at first .”

        Only if your holding period is quite long. Too bad many investors/landlords think three to five years is a “long” hold.

        The “bit better” you mention is not enough of a margin.

    • Vaughn K.

      The general principle is of course sound… But the specifics of 50%, not so much IMO. By that metric 100% of decent sized apartment buildings should not be bought by anymore, and probably 90% of smaller residential either. There are probably some entire states, and certainly many metro areas, where not a single property could ever meet that goal.

      In an area with $500K houses, your expenses tend to work out as a smaller portion of the whole situation. It is more expensive to install a roof in an expensive metro, but it isn’t 10x the cost as in an area with $50K homes.

      Bottom line is leave yourself plenty of breathing room. Do all the math up front, based on your area, if you can. Then you know what is what. Roughing out what a roof will cost you in 10 years when the current one will likely be bad isn’t tough, nor is pricing out a new hot water heater since you can tell the current one is at least a decade old, etc.

      • chris schu

        Unfortunately, stretching the numbers to appease the emotional need to have property in ones portfolio is a temptation many succumb to – and pay the price.

        As in any industry, riding the line eventually catches up to you, “OVER TIME”, as Mike accurately put it.

        Leaving “…plenty of breathing room” is as simple as calculating historical reserves yet we see “investors” pinch that number too – and suffer the consequences.

  2. Christopher Smith

    Agreed, as far as I am concerned an adequate margin of saftey hasn’t been available for awhile now (certainly not in my neck of the woods – CA East Bay).

    I stopped investing locally in 2013 and then in other markets (Midwest) in 2016. My only recent RE investment was in a REIT mid 2018. Buffett is typically looking for something in the range of a minimum 30 to 40 percent discount from FMV (that’s investing nothing after acquisition either – a true discount).

    Not sure how that would even be remotely possible in this environment with all the bloated pricing. Yet as always it seems as if these times are precisely the times that attract the most yahoo’s – like moths to a flame.

    Maybe it’s all the RE promotional hucksters selling the plug and play fairy tale about how easy it is to make a million in short order, or maybe it’s the overly easy access to credit (like 2007). Whatever I think there are going to some disappointed cowboys when they find out when you invest without a significant margin of error you’re tempting fate.

    • Paul Moore

      Hi Christopher, I agree the Bay Area has long been overheated. There are good deals to be had, but often most people don’t hear about them because they were sold off-market. And I am also with you that a lot of inexperienced investors will be in trouble when the market takes a turn. Be fearful when others are greedy and be greedy when others are fearful.

      • chris schu

        “Be fearful when others are greedy and be greedy when others are fearful.”

        I see Warren Buffett quotes are quite popular in the comments.

        Indeed, Buffett has had a big chunk of cash sitting on the sidelines lately. Hmmm…

    • Vaughn K.

      It is a funny thing to watch… People always flock to runs right as they are turning. I have never been able to understand it. I knew people with cash SELLING stocks at the bottom of the market! When there was no need for them to do so as they were fine financially. It’s mind blowing.

      It’s so EASY to see it too, at least for me. If you look at fundamentals, that almost always tells the story. You can never predict the exact moment that the irrational exhuberence of morons will run out and the market will collapse, but you can tell it is coming sooner or later from the fundamentals. IMO Stocks are there now, and trendy metro areas are there. Many parts of the country seem to “about right.” This is to say they’re not “deals,” but they’re not insanely overpriced either. Metals, especially silver, seem under priced. So do some other commodities. I don’t play that game, other than casually buying some silver and gold when I think the market is especially low.

      It’s not that tough to see this all, it’s right in front of every ones faces… But they can’t seem to see.

      I’m just waiting to see when it all comes crumbling down now.

      • chris schu

        ” irrational exhuberence of morons”

        My thoughts exactly.

        However, I’m surprised that phrase hasn’t triggered a few politically correct regulars who’ve lambasted me for saying much less “offensive” things.

        Truth hurts.

    • chris schu

      “…attract the most yahoo’s – like moths to a flame.”

      Yep! Time to sit on the sidelines or cash out in that area. You mentioned “Buffett”. Good. The younger crowd isn’t likely to have ever heard of Kenny Rogers’ song lyric: “You got to know when to hold ’em…know when to fold ’em…know when to walk away…know when to run”

      There certainly are going to be “…some disappointed cowboys…” that threw caution to the wind.

  3. brian ploszay

    Purchasing undervalued real estate is quite hard, especially these days. I’ve got two choices in my local market. First, find an underpriced asset. Second, buy properties in several up-and-coming areas, that are experiencing a revival. Both these choices are hard in 2019, a year where transaction volume is probably going to decline across the board.

    Solid advice from the author about safety margins. During the last downturn and subsequent wave of foreclosures, there was no reason for an apartment building owner to let go of their property – unless they overleveraged it. The rental market picked up steam in those years, even as the asset pricing was falling.

    There are many other ways to unlock value in your current portfolio – mostly through better management. Don’t treat your real estate as passive income -when there is a building that needs to be taken care of, to be managed. You’ll lose value eventually by being passive.

    • Paul Moore

      Brian, thank you very much for commenting. In response to what you said about ways to unlock value in your current portfolio, I could not agree more. The multifamily operators who lose during recessions are the ones who are not actively managing their projects. You can’t trust a property management company to do everything correctly for you. There are always small tweaks and improvements that can raise value.

  4. Neil Henderson

    Great post Paul! None of us can predict the future, the only thing we can do is protect our downside risk. What you CAN control is what you pay for a property. If it’s cash flowing, with a healthy margin of safety built in, you can withstand a lot of temporary setbacks.

  5. Vaughn K.

    One must always have some sort of safety margin. This is what always kills high flyer types. They hit one little hiccup, and if they’d just kept even minimal reserves they would have been fine… But noooooo. Always keep an emergency fund around sufficient to weather some hard times.

    The one caveat I would throw into this is that it depends on the timing. IMO, if you’re just coming out of an obvious massive bottom, like the Great Recession, or major stock market slump, etc AND if the fundamentals all look VERY GOOD… IMO that is a time one can afford to be a little more pedal to the metal.

    Basically if you asses the situation, and there is no real possibility of things taking a nose dive further, because it’s already gone as low as it can… It’s a REASONABLE risk to take. It IS still a risk, but it’s not a huge one if you’ve done proper due diligence.

    With all the market history, and market behavior patterns that are known to people with a little research today, I don’t think it is that hard to know when you’re close to the bottom. You can’t know the very, very, VERY bottom for sure, but you can surely tell when there is almost no downside left, and a lot of upside to come. Like was 2009, 2010, or 2011 the VERY bottom? Nobody could have said with certainty for sure back then, BUT it was pretty darn easy to know that there were a TON of good buys in RE and stocks during that time period.

    Even in such a situation, you need reserve funds, and to make sure your cash flow situation is enough to keep you covered. I’m just saying when you know you’re close to the bottom of a market that either already has, or will be turning soon… You can be a bit more aggressive than would be prudent at a time like now, where we’re clearly at, or close to, a peak.

  6. Evan Murnighan

    Great article! It brought home why I’ve not jumped into a property investment fund (have had that gut check) that my heart REALLY wants to (nostalgia is a dangerous foe) but could go very wrong due to the inflated multi unit market, despite the fund’s good history. Thank you for sharing your thoughts/wisdom.

    • Paul Moore

      Great call, Evan! There are certainly ways to still do well in a downturn, but I am looking forward to getting properties at a discount at some point when/if the market turns. The hardest thing will be to invest in a downturn when everyone around is panicking.

  7. Tyler Warne

    Great article! Warren Buffet and his lifetime of knowledge is incredible. I am an appraiser and investor. Currently and always looking for deals all the time and love getting and running numbers on whatever I can. With the increases in interest rates (Risk free rate) over the past 12 months: (5 – 25-basis-point increases or +1.25%) this will pinch a 6 cap into not making any money over the risk free rate ( which I would prefer because you don’t need to do anything). Then some sellers will need to sell and again there will be 7, 8, 9 and 10 or better Cap rates( the land of reasonable returns). Talking with a lender they predict higher interest rates for 2 years, then a decrease again. I don’t think anyone should try to push a rope – it doesn’t work.

    Just don’t buy bad deals!

    Warren also has a statement about risk, “When the tide goes out, then you can see who is swimming without a bathing suit” As this tide goes out we shall see who is not using a margin of safety. Thank you for the article!

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