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.
Related: Three Warren Buffett Quotes that I follow in my Real Estate Business
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.
Related: Real Estate Investment Advice From Warren Buffett
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 …read more