How to Flip Like Warren Buffett
Don’t look now, but Warren Buffett is now getting more involved in the real estate world.
Now, for most veteran stock investors, Warren Buffett needs no introduction. He is the chairperson of a holding company called Berkshire Hathaway, and is arguably the most successful investor alive. He doesn’t owe his fortune to a great invention or a single great product. People can get lucky with that. Rather, Buffett built his fortune the same way you can: by accurately identifying undervalued investable assets, buying them for less than they are worth, waiting for reality to catch up with your buying decision, and doing it over and over again.
Warren’s newest venture comes in the form of Berkshire Hathaway HomeServices, a new real estate franchise firm that just began operating last fall, and which is now poaching local and regional franchises from Prudential and other firms around the country.
Now, Buffett is not normally known for real estate. He’d probably tell you himself that he’s better at analyzing a company financial statement than looking at a piece of land. But he’s not hostile to real estate in the slightest either. Indeed, he recently told an interviewer he’d much rather own all the farmland in the United States than all the gold in the world. “A productive asset is going to kill an unproductive asset every time,” he explains.
Furthermore, Buffett is not normally a flipper, either. His favorite holding period is “forever,” and he does typically hold on to stocks and companies for many years.
But his conservative, countercyclical and rational approach to investing is timeless and valuable information for real estate investors of all stripes – even the flippers.
What can house flippers learn from this long-term stock guru?
1. Minimize risk.
“Don’t risk money you have and need for money you don’t have and don’t need.” This is, of course, another way of stating advice my grandfather gave to me many years ago: Don’t make bets you can’t afford to lose. None of your real estate deals should threaten your own home or the stability of your family. Limit your bets, keep leverage under control, and use entities as appropriate to protect your personal assets from mistakes you might make as an investor. You don’t have to get rich on any one deal. Take the singles, and the extra base hits will take care of themselves.
2. Buy at a discount to the intrinsic value of the investment.
Well, what does “intrinsic value” mean? In the investment world, intrinsic value is the net present value of all the future streams of income the investment is likely to generate. That’s it. Sentimentality, emotionalism and the madness of crowds don’t factor into the number.
And that’s worth a lot by itself. Bubbles, by definition, aren’t fueled by a sober and rational analysis of expected future cash flows. They are instead fueled by a speculation that some greater fool will come along and buy the property from you at a price even dumber than the one you paid for it.
Yes, these people can do very well for a while. And they can be very obnoxious while their strategies are working out. But what they are doing is simply piling more and more risk onto their portfolio without any kind of intrinsic value to back it up. Their entire investment thesis hinges on being able to find some other sucker to buy your asset from you for an absurd price in the future.
At some point, the last sucker in the market is you.
What’s the intrinsic value? Glad you asked. In investment terms, that’s the present value of all the income the property is likely to earn in the future, hedged for the fact that a dollar today is worth more than a dollar next year. If prevailing interest rates are, say, 5 percent, that means that next year’s dollar is worth 95 cents today. And a dollar promised the year after that is worth just under 90 cents, etc.
What’s that? You want to flip, not rent? That’s fine. The intrinsic value of the property is what’s going to preserve the price of the property. By buying a property for less than the intrinsic value of the future stream of rental income, you can be assured that a rational buyer will pay you at least what you paid for it. This is the best guarantee against loss you can have. If no one buys the property, you could happily rent it out, in theory, and do just fine.
3. Remain within your circle of competence.
Warren Buffett knows insurance stocks like no one alive. He understands risk underwriting, premiums, floats, and how it all fits together. He’s very sharp with banking, and manufacturing and consumer products. He likes things that are very simple and easy to understand: Gillette Razors, Coca Cola and See’s Candy, for example – and avoids investments he doesn’t understand.
He’d tell you himself, he doesn’t understand technology. He doesn’t know how to value it, and doesn’t understand competing technologies and how to predict if a technology will quickly become obsolete. He avoids investing in things in which he does not bring a substantial intellectual advantage to the table.
Flippers should keep it simple, most of the time, and stick to neighborhoods they understand, where they know valuations, trends and risks very well, and where they have a solid understanding of needed repairs. If you’ve never even repaired a broken hinge, you probably don’t want to be relying on adding a second story to a home to unlock the home’s value. You just don’t have enough experience with major renovations to truly understand how long it will take and what the process will cost. You could lose your shirt because you don’t know how to price a house that needs major renovations. Those are outside your circle of competence. Concentrate on the things you know stone cold.
4. Insist on a margin of safety.
Murphy is alive and well in the property-flipping business – and Murphy’s Law wreaks havoc on everyone with more than a few deals under his belt. The problem comes when the investor is counting on everything going right.
We say buy at a discount to the intrinsic value. That discount has to be substantial. Warren Buffett warned students in a famous speech, The Superinvestors of Graham and Doddsville,“You do not cut it close!”
“This is what Benjamin Graham meant when he talked about having a margin of safety. You don’t try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds. But you only drive 10,000 pounds across it. The same principle works in investing
5. Don’t lose money.
Warren Buffett likes to joke that he has two major investing rules: 1.) Never lose money! 2.) Never forget Rule #1!
Obviously, Buffett takes risks. He doesn’t like to keep money in TIPs and money markets if he can find a better idea. But Buffett has a sort of counterintuitive approach to reducing risk: The better the bargain, the lower the risk. A simpler way to say it is: Make your money when you buy, not when you sell.
“If you buy a dollar bill for 60 cents, it’s riskier than buying a dollar bill for 40 cents,” writes Buffett, again in “Superinvestors of Graham and Doddsville,” “but the expectation of reward is greater in the latter case.”
This is a very different thing from stubbornly holding on to a property, insisting that a buyer offer you what you paid for a foolish purchase so you don’t have to take a loss. We know from the last collapse in home prices that such a buyer may not come for a long while!
The flipper who bought a property at a discount to its intrinsic value doesn’t have to worry much about that.
6. Integrity is key.
Buffett gets calls almost every day from successful entrepreneurs looking to sell their businesses. This is because he has a reputation as being a straight shooter, an honest guy, and he is known to be able to make decisions and act on them quickly. He also has a reputation for dealing fairly with a company’s existing employees and management team.
His letter to his own managers is worth quoting at length:
We can afford to lose money – even a lot of money. But we can’t afford to lose reputation – even a shred of reputation. We must continue to measure every act against not only what is legal but also what we would be happy to have written about on the front page of a national newspaper in an article written by an unfriendly but intelligent reporter.
Sometimes your associates will say, “Everybody else is doing it.” This rationale is almost always a bad one if it is the main justification for a business action. It is totally unacceptable when evaluating a moral decision. Whenever somebody offers that phrase as a rationale, in effect they are saying that they can’t come up with a good reason. If anyone gives this explanation, tell them to try using it with a reporter or a judge and see how far it gets them.
If you see anything whose propriety or legality causes you to hesitate, be sure to give me a call. However, it’s very likely that if a given course of action evokes such hesitation, it’s too close to the line and should be abandoned. There’s plenty of money to be made in the center of the court. If it’s questionable whether some action is close to the line, just assume it is outside and forget it.
As a flipper, you want to be the Warren Buffett of your neighborhood. You want the same kind of reputation in your corner of the investment market that Buffett has in his. That way, you’ll get the pick of the litter when people in your market are looking to sell a house quickly – before any real estate agent even hears about the deal.
But be vigilant about your reputation. As Buffett is fond of saying, “It takes 20 years to build a reputation and five minutes to ruin it.”
