Margin of Safety in Your Investing

My wife is absolutely amazing. She is brilliant, funny, and attractive however, if I watch her pour of cup of coffee to the VERY top of her coffee cup one time and spill it all over the counter and floor, I AM GOING TO LOSE MY MIND!!! One morning after watching this inevitable sequence unfold, I yelled, “what if we paid full price for every rental property?!?!” As bizarre of a question as that was, my point was I don’t understand why she doesn’t allow for some spillage/mistakes. Not surprisingly, she just stared at me and I could tell she was trying to decide if it was in her best interest to go to a speed dating event that night to find a more suitable life partner or slug me in the face. Thankfully, she just simply walked into the next room without the slightest acknowledgement of my random tangent.

Whether it is a cup of smoking hot coffee that will very likely be spilled or the purchase of an investment, it is best to give yourself a “margin of safety” whenever possible. Ben Graham, one of Warren Buffett’s original mentors, made this idea famous in the investment world many decades ago and it has since been modernized by the brilliant hedge fund manager, Seth Klarman with his book “Margin of Safety”, which sells USED for $850 currently, not a typo. The premise with margin of safety in our investing life is to make an investment with as little downside as possible. Ben Graham used to purchase companies that were selling for less than Book Value, meaning that if the company went out of business, the shareholders should be able to recoup their investment capital from the sales of the product and equipment owned by the business. Seth Klarman is a rare bird in the modern hedge fund world in that he rarely uses any leverage at all and tends to hold a significant percentage of assets in cash. I watched an interview where he explained that it is arrogant to purchase or sell an asset as you are assuming you are right and the person on the other end of the transaction is wrong. For me, that was eye opening for a multi-billionaire to have such a humble approach to the purchase or sale of an asset. Seth is seen as a value investor, meaning that he tends to purchase an asset when the price of the asset is selling for less than it has previously and he believes it will be worth far more in the future. Unfortunately, many investors see an asset as “more risky” if the property or stock is selling for 30% less than it was 3 months ago, while value investors see this as opportunity to analyze the asset to see if it may be an opportunity to buy the asset on sale.

There are a number of ways that you can employ a margin of safety in your real estate investments:

• Ability to purchase at a discount– It is very possible to purchase a home for less money than similar homes on the street are selling for. Maybe the house is in disrepair and thus the owner is willing to sell for significantly less than the “as-is” value. For example, lets say that it is a cookie cutter neighborhood and the 3/2, 1,200 sq. ft ranch sells for around $150k, You find a For Sale By Owner sign, contact the owner and find out that it is a first time landlord that had nightmare tenants and HE WANTS OUT. After doing your homework, you come to the conclusion that the property needs $20k in repairs, and he is willing to sell it for $100k. If you are willing to do the work, or hire contractors to do the work, you will end up owning a $150k house for somewhere around $120k! Not bad if you are getting into the game! With challenge with securities (stocks, bonds, and mutual funds) is that if the company is selling for $10/share, you are going to pay $10/share if you want to purchase an ownership in that company.

• Purchase with sound financing or cash– There is a saying in real estate, “it is tough to lose a paid off house”, meaning that if you can pay cash for a property in a solid neighborhood, you are most likely to make good money renting it out, assuming you qualify your potential tenants. I would also add that good, long-term fixed loans like a fully amortizing 20 or 30 year, conventional loan is a solid option as well. You will have a low payment, that is fixed regardless of what interest rates do in the future and you can also pay it off sooner, should that be your goal.

• Simplicity of the investment– The stock market is a complicated monster with a lot of moving parts. I am a special kind of stupid in that I have actually read the annual reports and gone through a thoughtful process and STILL gotten it completely wrong. So I have decided that the only way that I should participate is by purchasing low cost index funds (I like VTI), and boring blue chip stocks like AT&T. With real estate, I find that I can drive a neighborhood and have a reasonable understanding of whether a quality tenant would want to live there. I also have the ability to take a walk with my wife and talk to neighbors about whether it is a safe area and if they like living there. You will be amazed by what you will learn and every once in a while they will tell you about a neighbor that is actually thinking of selling! I can add additional safety by talking to other landlords that own properties in the neighborhood to get a feel for the type of tenant that the neighborhood attracts. Nothing fancy, just some common sense research. Of course you will do your own homework on the values in the neighborhood, but you have additional resources to help you with the value when you get the house appraised, which will be mandatory if you are using bank financing for the purchase. If you have a contract to buy the house for $100k and it appraises for $80k, rejoice, the appraiser just saved you from overpaying! You may decide to renegotiate or perhaps take this as an opportunity to realize you need to spend more time understanding values and perhaps buy a local investor lunch and pick their brain. It is possible to get a poor appraisal, usually from an out of town appraiser, but at the very least, you are now aware that you are not purchasing the house at a discount.
• Bonus Round: Illiquid Nature of real estate– I fully expect to have massive disagreement with this one but here we go! I see the relatively illiquid nature of real estate as a huge benefit. It is inevitable that you will have a bad tenant, a run of expensive repairs, or the real estate market can soften and the value of your properties can go down. Admittedly, there are days where I do think about selling all of our properties. I then have the benefit of sitting down with a friend in real estate or my business partner aka my wife, and I have an opportunity to get a little perspective on the situation because the reality is that I cannot sell a property on the very day that I am mad. Even if I agree to sell my property to another investor at a STEEP discount, it will still take at least a week or so for the sale to go through and by that time, I have calmed down and moved on from the frustration. I have also noticed that the real estate investors that did well through the 2008 collapse were the landlords that had solid, long term debt on their rentals, if they had a mortgage at all. They were still collecting their rent and the rents only pulled back about 10% in our area. Honestly, 10% is a rounding error when it comes to rentals. There have been many times when I have purchased a property only expecting to get $900-$1,000 in rent only to realize that I could get $1,200. It pays to be conservative. With stocks, I can have a bad day at work and decide to decompress by pulling up my portfolio only to realize the tech stock that I invested in is down 8% today, because they missed their quarterly earnings projection. I can decide to sell immediately because I got the stock tip from my idiot sister-in-law who is dead broke. Maybe selling is a good idea as they end up going bankrupt in 3 years but maybe they become the next Google. I have no idea, that is why I don’t obsess over the ups and downs of the individual stocks that I purchase. To be honest, once I buy the stock/index fund shares, I don’t look at it again. I made the financial commitment and I can’t second guess it based upon what is going on with me or the company in that moment.

We will never be able to see every angle in life or investing. It is unreasonable to assume that there will be complete information to make decisions but I do firmly believe that we can stack the deck in our favor by giving ourselves room for error.

Do you fill your coffee to the very top of the cup? How do you mitigate risk in your investments?

For more information, please visit The Lousy Investor.