Wise people, like Warren Buffett, don’t bother wielding steel to defend what they like. He might be the world’s most famous stock investor, but there’s plenty he can teach about real estate too.
Buffett made his fortune running the insurance company, Berkshire Hathaway. His company insures other corporations. Those corporations make regular payments to Berkshire, known as premiums. In insurance-speak, accrued premiums are known as the float. Over time, Berkshire Hathaway’s float far exceeded what it paid in insurance claims. Buffett invested that float in private and public businesses. Those businesses paid cash dividends. Their shares also increased in value, and Berkshire’s share price reflected that growth. Buffett became the company’s chairman in 1965. If you had invested $100 in Berkshire Hathaway stock back then, it would have grown to $2 million by June 25, 2019.
In other words, Buffett might be the world’s best business-buyer. And when people buy an investment property, they’re buying a business. Like any company, investment properties have a price. They also have earnings, if they’re being rented.
Rule #1: Show Me The Money
Warren Buffett’s investment rules are remarkably consistent. They’re best collated in Lawrence Cunningham’s book, The Essays of Warren Buffett. When he’s looking at a business, Buffett calculates the earning’s yield. In other words, if a company is selling for $1 million, and its annual revenue, after expenses, is $100,000 a year, then the business’ yield is 10 percent (100,000 divided by 1,000,000 = 0.10). When Buffett considers buying a business, he compares the earning’s yield to that of a risk-free 10-year treasury bond. If the yield is much higher than a treasury bond, it piques his interest. By comparing investment yields, Buffett can compare one company to another.
Investors should do the same with real estate too. Property yields can vary a lot. For example, consider two properties. They each cost $500,000. The renters in the first property pay $50,000 a year. That’s a 10 percent yield. The renters in the second property pay $20,000 a year. That’s just a 4 percent yield, which isn’t much higher than the yield on a 10-year treasury bond. If the condition of the properties and the quality of the tenants were the same, the higher yielding property should look like a diamond next to a potato.
Rule #2: Do You Know What Could Change The Yield?
In 1993, Warren Buffett bought some commercial real estate. He reveals the story in his 2013 letter to Berkshire Hathaway shareholders. The yield was 10 percent. He also knew that one of the tenants had signed a long-term contract at a low rent level. When that contract expired, the earning’s yield would soar. “The unleveraged current yield from the property was about 10 percent,” he wrote. “But the property had been undermanaged…[and] the largest tenant — who occupied around 20 percent of the project’s space — was paying rent of about $5 per foot, whereas other tenants averaged $70. The expiration of this bargain lease in nine years was certain to provide a major boost to earnings.”
You might not be so lucky. But if several new businesses are moving into an area of interest, this might also boost rents, raising yields along with it. However, like Buffett did when he made his purchase, make sure any yield is already strong before you buy.
Rule #3: Avoid Speculation When Embracing Location
Plenty of real estate investors focus on location, and for good reason. But Buffett says investors should focus more on earnings. In other words, a great location might mean you can attract great tenants and charge them a premium over a less desirable space. But if real estate investors want to follow Buffett’s tenets, they shouldn’t buy a property just because they think the price will rise. As Buffett wrote, “If you…focus on the prospective price change of a contemplated purchase, you are speculating…I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so.”