Many investors lose money on some real estate investing deals, and for one major reason. It’s unfortunate, because you can easily avoid this major pitfall. It’s not complicated but it requires an understanding of why real estate entrepreneurs fall into this trap as well as how to cultivate the discipline to stay out of it. Learn about margin of safety and how it applies to real estate investing. And fascinatingly enough, this lesson applies to all investors, not just real estate investors. You’ll learn about the history of this wisdom and who made it popular. Most importantly, by heeding this warning, you’ll equip yourself with knowledge that could save you from financial disaster. Here’s the #1 reason why investors lose money:
What is the 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.
Also known as “margin of error,” margin of safety is the notion that you’ll create a deal with room for error. Mistakes in a margin of safety analysis are going to help protect you by making sure that you’ll still make money. Even if it’s not as much as you had expected, or hoped you would. The whole point of a margin of safety is to protect you from a major hit. Buying at a good price will create a margin of safety that can protect you from further downturns in the real estate market or buying the wrong house. Margin of safety is a principle of investing in which an investor only purchases securities when the market price is significantly below its intrinsic value. In other words, when market price is significantly below your estimation of the intrinsic value, the difference is the margin of safety. This difference allows an investment to be made with minimal downside risk.
How does this apply to real estate?
A margin of safety concept can be applied regarding any real estate issue. For example, all-cash purchases, down payments, or hard money loans. The concept also can apply to house flips, auctions, or fixer-uppers. You should apply a margin of safety to any property that is to be closed on.
Are there any exceptions?
If the real estate deal is one that you don’t need to close on, you don’t need a margin of safety. For example, if you are receiving commission on a deal, or doing a deal that assigns your interest; and, deals that are flipped right away without any credit or cash put toward it.
Calculating your margin of safety
It’s important to understand that a margin of safety isn’t necessarily a percentage. Why? Because percentages naturally break down when the property gets really high or too low. A margin of safety is actually just an instinctual decision when you are analyzing the data.
Most common mistake
The After Repair Value (ARV)
The After Repair Value (ARV) of the property is what the property is going to be worth when you are buying it. It’s normal for real estate investors to get really excited about a deal, and over-estimate what the property is going to ultimately sell for. Other times, they may completely under-estimate how much money it is going to cost them to fix it up. When investors look at a property, they generally assume it isn’t going to need too much work. Yet, many times there are lots of problems with the house that just haven’t been determined yet. This is why when it comes to analyzing the margin of safety, you should plan for the worst. While the “comps” can provide a lot of insight about a property, there are some things that just can’t be accounted for that you won’t know about until later. Don’t assume that the property is going to profit what you think it will.
You should be pessimistic when it comes to calculating the margin of safety. Assume the house is going to sell for less than you think it will when you buy it. Also assume it is going to cost you way more money to renovate than you think it will. Add about 25% to whatever you think the renovations will cost, for example. Then assume it’s going to sell for 15% less than you expect it to. Looking at it that way will help you determine the margin of safety. What’s great, is that on the other hand, sometimes your margin of safety is wrong and you end up making more than you thought you would. Yet, it’s better to have an attitude of preparing for the worst, and hoping for the best.
Resist impulsive decisions
You absolutely must have discipline when it comes to making decisions on a deal. It’s really hard to not get excited about a potential deal, but you must not be impulsive. The golden rule of real estate investing is to not lose money. Even if you only break-even or do a tiny bit better. This is why having a margin of safety is so powerful.
It may mean less deals
Does this mean that you’re going to have less real estate deals in your portfolio? Probably. Because you’re going to learn that there are more properties to walk away from than you would have before applying the margin of safety strategy. This is a good thing. Many investors think the more deals they’ve got going on, the more successful they’re going to be. Think about Monopoly; you can own almost every property on the board, but that doesn’t guarantee you’ll win the game. It’s about which properties you have.
Things required for an investment
In order for a real estate deal to be considered an investment, you must actually make sure of three things:
- 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 versus quality debate
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. Buying properties that are significantly below value 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. Your margin of safety is the difference between the price you pay for an asset and how much that asset is truly worth. Your fundamental analysis will not always be right. You will not always be able to predict unforeseen events. Should such events occur your investment will have a large cushion built into it to protect you against significant losses.
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. If you want to make money in real estate, before investing in your next multifamily project, make sure you know the answer to these questions:
What is the properties break-even occupancy?
What is the market’s current and historical occupancy rate?
What is the property manager’s historical performance in your given market?
The best real estate investments are multifamily and the investor can realize significant financial growth and make money in real estate if they pay attention to break-even occupancy.
Benefits to investing in real estate
There are many ways to profit from real estate investing. When you purchase a company’s stock certificates, you’re looking for appreciation in the stock value, and perhaps dividend income if the company pays it. With bonds, you’re looking for income yield on the interest rate paid by the bonds. With a real estate investments, there are more ways in which to realize a superior return on investment. Learn the ways in which your real estate investment can increase in value, as well as provide good cash flow.
You can lease to own as an investor with little of your own cash. Lease to own for real estate rental property investing isn’t a flipping strategy. It’s a long term hold for cash flow technique. The rental property investor wants to own the property for a number of years, actually, as long as it is producing acceptable cash flow and isn’t requiring extensive renovation.
Rental properties normally appreciate in value with inflation. Increased value can mean sale and reinvestment in higher value properties, or provide an equity line of credit to use for other investments. It is the second, and a historically proven, value component of real estate investment return. Cash flow is the main reason most investors love rental properties. If you’re considering investing in real estate rental property, there is a lot of research to do. You should also be sure that you’re suited to being a landlord, and that you have the time to manage properties.
What does “breaking even” mean?
In simple terms, to break even on your real estate investment property means that the amount of income which your property generates for you is equivalent to the size of the costs which you need to pay for this property. In other words, your cash flow has to be zero so that you are breaking even on your income property. The main numbers which you will need to consider here are:
- Cash flow of rental income
- Taxes, insurance, maintenance, and the like
- The mortgage
If your rental income is able to only cover your operating expenses and loan payments, you will break even. Be careful when making the calculations because you should factor in the tax deductions to which you are entitled as a landlord. These include deductions related to interest, depreciation, insurance, repairs, supplies, travel, employees, and legal fees among others. All possible deductions are important because they might make all the difference between losing money on your rental property and breaking even.
It is OK to buy an income property that is able to only cover for its expenses in the short term as long as you have solid reasons to believe that this will change in the future and your property will start generating income. Still though, if you can instead find a property which you can afford and which provides profit since the beginning, it might be a better idea to go for it.
In most cases, rental income is expected to increase over time. Due to population growth, inflation, and economic growth, rents are set to go up in the medium and long run. Sometimes even in the short term. At the same time, once you’ve signed the mortgage contract, your monthly loan payments will remain the same. Operating expenses will also rise but less than rents. This means that your real estate investment property will provide you with more and more income while expenses will remain relatively unchanged. So even if your property is initially just breaking even, it should be able to start bringing profit soon.