Some of the most successful stock investors ever have based their investing principals on value investing. Investors such as Benjamin Graham, Irving Kahn, and Warren Buffet, 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 to be learnt from value investing that can be applied to other investment vehicles. This article will show 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 operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative”.
So, there are 3 things needed for something to be an investment:
– You need to have done 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. If you’re buying properties at random, just because there is a boom and all property is 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 are speculating, versus when you are investing.
Value vs Quality
Value Investing doesn’t really have any 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 their 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.
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 a good strategy for real-estate investors to move to later on, when they have built up their portfolio. Long term, well-chosen property will make significantly more capital growth than poorly chosen property, and may be worth buying even if it can only be bought at market value.
And with commercial real estate investment, it may be worth getting a lower rental yield, if this means you can have a high quality tenant, who will pay the rent reliably.
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. There is no way your analysis can 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 etc., to come up with the value. If your estimated value comes in at $10, then you don’t buy the stock if its currently selling for $9.75, because it’s too risky, and if your calculations are off, you won’t be buying a bargain. If the price is currently $6 though, you might buy it, because you have a $4 margin of safety to use if you estimated incorrectly.
The same principal applies to real-estate. Suppose you are looking at a deal, and you find you can buy some land for $100,000 and you can 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 at $270,000 so you should make $20,000 profit.
But that isn’t much margin of safety. What if building costs blow out, and it cost more than $150,000 to build? What if you can’t sell it straight away so you have some holding costs? What if the other 4-bedroom houses in the area have much better kitchens than you realized, and you can actually 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 making a loss.
If on the other hand, 4-bedroom houses in the area are selling for $350,000 then you have a projected profit of $100,000. You can afford for a lot of things to go wrong, and you can still make a profit. In the first case, if building costs go up by $50,000, the deal will cost you $30,000. In the second case, because you have a much larger margin of safety, if building costs go up by $50,000 then you will still make a 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
Conventual 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 is 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 made.
This doesn’t mean than high reward always means lower risk though. The conventual Risk vs Reward wisdom is still correct in general. 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.