Some of the most successful stock investors have based their investing principals on value investing. Investors such as Warren Buffet, Benjamin Graham, and Irving Kahn have used value investing to build vast empires of wealth.
Value investing was conceived by Benjamin Graham and David Dodd, in their classic book, “Security Analysis”, written in 1934. Although they were talking about stocks, there is still a lot we can learn from value investing that can be applied to other vehicles such as investment real estate.
Keep in mind that the very definition of value investing is subjective. Some value investors only look at current returns and don't place any value on future growth. While other value investors base their strategies around the estimation of future growth and cash flows. Despite the differences, it all comes back to trying to buy something for less than it is worth.
Here are four things that real estate investors can learn from value investing:
Investing vs. Speculating
In value investing, it's important to make the distinction between being an investor, and being a speculator. In “Security Analysis”, it is defined as this:
“An investment…is one which, upon thorough analysis promises safety of principal and an adequate return. [Investments] not meeting these requirements are speculative”.
So there are 3 things needed for something to be an investment:
- You need to do a thorough analysis.
- You need to be reasonably sure that you won't lose your money.
- You need to be reasonably sure that you will make some money.
In terms of real estate, this means that just buying and selling real estate does NOT make you an investor. Even if you're buying properties at random because of a real estate boom, and all other properties are going up in value, you are not investing. You are speculating.
There is nothing wrong with speculating, you just need to be aware when you're speculating versus when you're investing.
Value vs. Quality
Value investing doesn't have any specific formulas, or rules. It is more of a theory with some general principals. Because of this, there are many ways to do value investing, and different ways to apply it.
Benjamin Graham focused on buying stocks significantly below value, with little emphasis in the quality of the stock in regards to its long term prospects.
This can be a useful strategy for a real estate investor, particularly when they are first starting out and need to build up equity fast. However, this would not be a very good long term strategy.
Warren Buffet still looks at the value of a stock, but puts a lot more emphasis on the quality of the stock. He only buys stocks that he thinks have good long term prospects, with a bright future in front of them.
This is generally the best strategy for real estate investors, especially as they build up their portfolio. Long term, well chosen property will provide significantly more capital growth than poorly chosen property, and may be worth buying even if bought at market value.
With commercial real estate investments, it may be worth getting a lower rental yield if it means you can have a high quality tenant who will pay the rent reliably. This is a strategy that famous New Zealand commercial real estate investor Bob Jones has applied with great success.
Margin of Safety
One of the most important principals in value investing is “margin of safety”.
Margin of safety is the idea of making sure that you only invest if your calculations show that there is a significant profit to be made. It is impossible for your analysis to be 100% accurate, so the margin of safety gives you a buffer to use when your calculations are slightly off, or you get worse than average luck, or any number of unexpected problems occur.
So when estimating the value of a stock, you use conservative estimates for earnings and so forth, to come up with the value. If your estimated value comes in at $10, then you don't buy the stock if it's currently selling for $9.75, because it's too risky, and if your calculations are off, you won’t be buying a bargain. However, if the price is currently $6, you might buy it because you have a $4 margin of safety to use if you estimated incorrectly.
The same principal applies to investment real estate.
Suppose you are looking at a particular investment, and you find you can buy a piece of land for $100,000 and build a 4-bedroom house on it for $150,000.
If new 4-bedroom houses in the area are selling for $270,000 then should you do the deal? Theoretically, it will only cost you $250,000 to buy/build with a sale price of $270,000, leaving you a gross profit of $20,000.
But that isn't much of a margin of safety. What if building costs increase and it costs more than $150,000 to build? What if you can't sell it right away and you now have some holding costs? What if the other 4-bedroom houses in the area have much better kitchens than you realized and you can only sell for $245,000?
There are a lot of unknowns here, and because your margin of safety is so small, unless everything goes right, you can quickly find yourself taking a loss.
If on the other hand, 4-bedroom houses in the area are selling for $350,000 then you have a projected gross profit of $100,000. You can now afford for many things to go wrong, and still make a profit.
In the first scenario, if building costs go up by $50,000, the deal will cost you $30,000. In the second scenario, because you have a much larger margin of safety, if building costs go up by $50,000, you will still make a gross profit of $50,000.
Margin of safety is a very important concept to all investors, and all real estate investors should think about it if they want to be around for the long term.
The Myth of Risk vs. Reward
Conventional wisdom says that to increase your reward in investing, you must increase your risk. This is often true, but the margin of safety principal can turn this around.
When margin of safety is used, a higher reward actually means a lower risk!
You can see this in the example above. The deal that is projected to make $20,000 is quite risky, whereas the deal with a projected profit of $100,000 is much safer because a lot more can go wrong before a loss is realized.
Of course this doesn't mean that high reward always means lower risk. The conventional Risk vs. Reward wisdom is still generally correct. So, if you borrow more to buy a property, your risk and reward have increased. If you buy in a small town to get a higher rental yield, your risk and reward have increased.
This Risk vs. Reward theory is only incorrect when directly applied to the Margin of Safety concept. So if you buy something for $100,000 that all your analysis shows is worth $200,000, then your reward has gone up, while your risk has gone down.
BOTTOM LINE: You too can be a very successful Value Investor. Along with thorough analysis, simply define your real estate investment strategy in terms of investing vs. speculation, value vs. quality, and margin of safety.