3 Business Tenets Key to Intelligent Real Estate Investment

Warren Buffett is a hero of mine. I certainly don’t claim to have his investing knowledge or mental abilities, but I enjoy studying the best of the best in our field of investing.

In 1950 at age 20, Buffett had a net worth of $9,800. By 2014 at age 84 Forbes reports his net worth to be $68.3 billion!

What makes Buffett unusual compared to other multi-billionaires is that most of his growth came from investments and not from starting and growing an operating business. This means he has a successful investment track record, so it pays to study his investing criteria.

In this article I will share Buffett’s top 3 business tenets, or the criteria he looks for in a business to purchase. I will also translate these general principles to our world of real estate investing. These lessons come from the the classic book The Warren Buffett Way by Robert Hagstrom.

Warren Buffett’s Top 3 Business Tenents

Buffett Business Tenet #1: Seek Simple and Understandable Investments

“In Buffett’s view, an investor’s financial success is in direct proportion to the degree to which he or she understands the investment. This understanding is a distinguishing trait that separates investors with a business orientation from most hit-and-run investors, people who merely buy shares of stock.” [my emphasis]

Robert Hagstrom, The Warren Buffett Way

Buffett owns a lot of different business, but he rarely buys companies that are hi-tech or computer focused. Why not? For him they are not simple and understandable.

Buffett is good friends with Microsoft founder Bill Gates, yet he doesn’t buy Microsoft because he doesn’t understand the intricacies of why and how Microsoft makes a profit.

In real estate, I translate simple and understandable into both the location of your investments and into the types and sizes of properties you buy.

When choosing a location to invest in, how many investors do you see with “the grass is greener on the other side” syndrome? They buy out of their hometown because they believe the cash flow or appreciation is better there.

I understand that for some big-city markets around the country the odds of successful, cash flowing investments are more difficult. But this does not change the fact that your own backyard is the simplest and most understandable market you can possibly invest in. The closer you invest to home, the more built in advantages you will have.

Why is this so? Because you are an end user in your local market on a daily basis. The trends and motivations that drive your market are likely intuitive to you, and thus they are more simple and understandable.

When you go to a market in which you have no affiliation or long-term connection, the odds are stacked against you. On the street, local knowledge matters. You might learn the large market factors from a distance, but the nuances and subtle competitive edges will still be in the hands of the local investors and can’t be picked up with a weekend visit or two.

Hiring a local acquisitions and management team is therefore a requirement, but you have now outsourced the most important and difficult-to-acquire competitive advantage: market knowledge. If you lose that team member, you lose your advantage.

The costs of travel, time and diversion of your focus must also be handicapped so that you adjust your real return to reflect this additional time, effort, risk and opportunity cost. You may find out that an additional 2-3% return for quality properties in another location is about the same as a local investment once you apply the discount. Or you might find that more diversified and passive stock index funds or REITS (like mutual funds for real estate) could accomplish the same thing with less time, effort and risk.

Within a particular location, I also find certain types of properties to be more simple and understandable than others. I have no problem with commercial properties in theory, but I find it doubtful that the average investor can understand the intricacies of business analysis and complex contracts that are a requirement for success in the commercial real estate world.

Much more simple and understandable are residential properties, and in particular single family houses and small multi-units. Because we have lived in a house, we intuitively understand what criteria make a desirable neighborhood and what features make a desirable structure and lot. When we understand those criteria, we can use that understanding to buy the best properties and to avoid the worst.

Bigger properties and more complex deal structures are overrated for the average small investor. Most of us can become very wealthy and happy keeping it small, local, simple and understandable.

Buffett Business Tenet #2: Invest in Areas With a Consistent Operating History

“Buffett’s belief is that ‘severe change and exceptional returns usually don’t mix’ … Energy can be more profitably expended by purchasing good businesses at reasonable prices than difficult businesses at cheaper prices.”

Robert Hagstrom, The Warren Buffett Way

Buffett would say that excitement and the best investments don’t usually mix. Buffett has bought many good businesses at reasonable but not bargain-basement prices, and these investments have provided him the best longterm returns.

Major turnarounds are exciting. Buying a block of houses in a rough area and changing the entire neighborhood can dramatically change rents and values. Taking a cheap apartment building in a borderline area, getting rid of the bad tenants and stabilizing rents can be very profitable (if all goes well and on time).

But both of these scenarios are speculative because there is not an existing track record of a consistent operating history in the neighborhood. This doesn’t mean that deals like this are not rewarding or important for society, but it does mean that you need to call it what it is (speculative) and build in a much bigger margin of safety.

My school of hard knocks has taught me that rarely do the lowest price deals compensate me enough for my investment of time, effort, and risk. If I paid myself for all of the extra time and stress I experienced on these deals, my return on capital would not be that good. It has been a good temporary job for me, but not a great investment.

The consistent and steady real estate investments have values and rents that are more stable. For my purchases, I start with this steadiness of location both on a macro and a micro level, and then I look for the “dog” — or an ugly property within that good location.

A mentor of mine explained to me once that a good deal is like your lovable dog who temporarily is very unattractive because it has those nasty little biting creatures called fleas. Who wants to cuddle with a dog that has fleas!? But once treated and cleaned up, your pooch will be back to her adorable, cuddly self. The same applies to dog properties in good locations once you turn them around.

Reasons for a temporary property downturn in an otherwise good location might include a number of personal situations like foreclosure, a retiring or burned out landlord, too much deferred maintenance, or an estate. It might also include problem tenants who can be evicted and then easily replaced with better tenants.

These are all problems that can be solved for a profit, just like getting rid of fleas from your favorite pet.

Buffett Business Tenet #3: Acquire Favorable Longterm Prospects (A Franchise)

“According to Buffett, the economic world is divided into a small group of franchises and a much larger group of commodity businesses, of which most are not worth purchasing. He defines a franchise as a company providing a product or service that is:

1) Needed or desired

2) Has no close substitute

3) Is not regulated.

These traits allow a franchise to regularly increase the prices of its product or service without fear of losing market share or unit volume”

Robert Hagstrom, The Warren Buffett Way

The distinction of a Franchise vs. a Commodity is a key investing lesson. The ability to raise prices faster and more often than competitors is the hallmark of a franchise investment. Think about Buffett’s long-time investment Coca-Cola, which basically sells flavored water at a huge mark up to its cost of production.

A commodity, on the other hand, is something like gasoline. As long as the gasoline runs the car, most people aren’t concerned whether they get it from Citgo or Chevron. If Citgo raises prices $.25 per gallon compared with Chevron, most people would shop at Chevron instead to save money.

Franchise pieces of real estate are much more rare than commodity-like properties, but finding them is a key to consistent long-term profits.

I made a YouTube video that explained Buffett’s concept of franchises in real estate by using another term he likes: castles with protective moats.

A moat is a competitive advantage that is not easily replicated. In real estate desirable locations tend to be the number one competitive moat. As a result it is easier to raise rents, lower vacancies and increase your profits in these locations.

Understandably, these desirable locations are also the hardest places to buy investment properties because the supply is low and the demand is high. But once you understand the longterm value and rarity of these properties, you can buy them at reasonable prices (based upon net operating income) and still make incredible longterm profits. Financing also plays a part in these purchases, so creative financing like leases, options, seller carry-back financing or partnerships may help you knock down the best deals.

I have had lunch several times with a veteran investor in my town who demonstrated this principle of franchise real estate to me. He owns THE prime piece of real estate in the center of the city. I asked him the story of how he acquired it.

He told me about how he initially struggled to find the down payment and to make payments when he first bought it. The seller financed much of the purchase to him. But now, 20+ years after the purchase, his rents are 11 times higher than before (which means $1,000/month rent in 1980 is now $11,000/month), and the actual value of the property has gone off the charts! To make the deal even sweeter, he also sold off a small piece of the property, got all of his original purchase price back and more, and he still receives this higher rent from the remaining parcel!

Other income properties in the same town, 1-2 miles away in less prime locations had rents that stayed flat or perhaps appreciated at rates of only 1-2% during the same period as this prime investment.

THAT is the power of favorable longterm prospects, a competitive advantage, a moat and a franchise. Buffett has experienced very similar results with some of his best franchises, like Coca-Cola, Geico, American Express, Sees Candy, Wells Fargo, and others.

Transfer Knowledge From One Arena to Another

I find it interesting and very profitable to learn lessons outside of my day-to-day niche of real estate investing and then transfer these insights back into my world. I hope you do, too.

I can’t recommend highly enough doing this by studying the investing decisions of Warren Buffett.

If you want to begin your study, I suggest starting for free with 36 years of Buffett’s letters to Berkshire-Hathaway Shareholders or a YouTube video of Buffett talking to MBA students at UGA (1+ hour long).

From there I of course recommend The Warren Buffett Way by Robert Hagstrom or his HUGE but very interesting biography, The Snowball: Warren Buffett and the Business of Life by Alice Schroeder.

I’d love to get your thoughts on the 3 business tenets above or other helpful ideas you’ve picked up from Warren Buffett.

Please share them in the comments section below!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.