You're about to discover the #1 reason why too many investors lose money on some real estate investing deals and how 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:
Where Investors Go Wrong
Margin of Safety
Margin of safety or margin of error, is the idea that you are going to build a deal with room for mistakes. If you make a mistake in your analysis a margin of safety will help protect you by ensuring that you still make money; even if it is not quite as much as you had originally hoped for.
Ben Graham
Benjamin Graham is the author of the book The Intelligent Investor, and Warren Buffett's personal mentor. He is also the person that brought the concept of a "margin of safety" to the mainstream world of investing advice. He believes in the idea that if you buy a stock you should build in a margin of safety to protect you if your analysis of the intrinsic value of the stock is off. If you make wrong assumptions or calculation errors, the margin of safety is there to protect you from a loss.
The same concept can be applied to any real estate situation such as: An all cash purchase, a combination of a traditional bank loan and your own down payment, or even a hard money loan and down payment, or subject-to, where you give the homeowners some money to catch up their back payments. It also applies to any type of real estate deal you close on such as fix and flips, fix and rents, auctions, wholesaler flip, or immediate resells. If the property is closed on, you should apply a margin of safety to it.
Exclusions:
Any deal that does not involve you closing on it, does not require a margin of safety. This includes deals where you are receiving a commission, deals that involve you assigning your interest, and deals that are immediately flipped without putting any sort of cash or credit towards it.
What Should Your Margin of Safety Be?
A margin of safety isn't really a percentage because percentages break down when the price of the property gets too low or really high. Instead, the margin of safety is a gut reaction when you are looking at the numbers.
2 Main Mistakes
Estimated value
It is also referred to as the ARV, or After Repair Value, but because not everyone will be fixing up their real estate property, I call it the "estimated value." The estimated value is what the property is going t be worth when you are buying. It is very common for real estate investors to be overly optimistic when determining what a property will sell for.
On the other side of the coin, they underestimate how much it's going to take to renovate. Investors will often look at a house and assume that it will only need some minor renovations, when in fact there can be huge problems just waiting to be found.
That is what is so interesting about the concept of margin of safety, because it is actually best to be pessimistic. You need to look at the neighborhood comps and determine all of the things that the other houses have that your house doesn't. Find the reasons why your property might not pull as high of numbers, as you originally thought.
Pessimism
Be pessimistic. I know it is a strange thing to read, but it is what you have to do in order to build in a margin of safety. You must be pessimistic on how much the house will sell for once you own it, and then you have to be pessimistic on how much it will cost for you to renovate it. You can try to apply some sort of rule of thumb, like adding 20% to your original cost assessment, and assuming it will sell for 10% less then you've predicted, but that breaks down a lot.
Example
I recently purchased a condo for $375,000 with an appraisal price of $600,000. This deal gave me plenty of wiggle room and the condo needed very little work, so I was very excited. But then after I closed on it I discovered that the condo did not have the correct kind of licensing for what is called a transient, which is where you turn the condo into a nightly rental. I also found out that it did not have access to the HOA amenities such as the pool or parking. Even though I had read through the HOA docs, I was in a hurry to close, and completely missed this information. Now, these two things might seem like minor details but they actually changed the property value by $100,000. Instead of $600,000, the deal is actually worth $500,000. Thankfully I had a margin of safety so I was still able to make some money off this deal, but what if I hadn't? If I purchased a property for $450,000, thinking it would sell for $600,00 but it ended up only being worth $500,000, that is a huge difference in potential income.
You Must Have a Margin of Safety
Applying this concept to all of my deals is the reason I have been successful year after year. During the meltdown and bursting of the bubble of the real estate market, I remained successful, by always implementing a margin of safety in all of my deals. I never took on more then I could chew, because even if my assumptions were wrong, I was still making money. The best part is that sometimes your assumptions and calculations are wrong in the other directions, and you actually end up making more money.
Discipline
In an interesting interview I watched with Warren Buffett and Steve Forbes, the editor of the Forbes magazine, Steve asked Warren a very simple question. He said, "A lot of people know about value investing and contrarian investing, the idea of evaluating the intrinsic value of a business or a stock, and waiting for the right price to buy it at, but Warren, you've been better than everybody at that. One of your major difference that made you better than everyone else was discipline." "You have discipline when you're making decisions, because it can be very tempting to want to take on a deal, especially if you want to have deal flow going on."
Real estate investors know what I am talking about. You feel the need to have some deals in the works, so that you are continuously making more money, so you are more prone to break some of your margin of safety rules and pick up deals at a higher price point then you should.
In the Warren Buffet interview, Warren said, "It is not always about the home runs I've hit. It's about all the deals that I didn't lose money on. You know, either I broke even, did a little bit better." He said, "The rule number 1 of investing is to not lose money, and rule number 2 is to not forget rule number 1." When you have this margin of safety, it's not always that you hit home runs, it's that you avoid going backwards, because going backwards can be incredibly debilitating. Not only demoralizing, from an emotional standpoint, but also from a financial standpoint.
Less Deals
When you are able to build in that margin of safety, you give yourself the opportunity to insure that even if your assumptions are wrong, you still make money. It requires discipline, because that means you're going to walk away from more deals.
Is that a bad thing?
At first glance it might seem like less deals is a bad thing. When you apply a margin of safety you will pass on more deals because they will not meet your new requirements. However, this is a safety net that assures you are not going backwards, which means the deals you are actually going to do are productive. This concept forces you to think in terms of how to monetize deals which means you will get better at flipping properties. You could even choose to get your real estate license in order to receive commission referrals.
I am very careful about the deals that I close on, whether I am putting my money or someone else into the deal. It doesn't make a difference because if you are going to be guaranteeing a loan or even if you are signing on behalf of your LLC, you need to do the right thing and make sure you are making the best decisions for the deals that you close on.
I hear a lot of people complain about how hard money lenders have a 65 cents on the dollar rule, which means that you need to buy the property at 65 cents of its today's as is value. People complain because they are not sure they will be able to find a deal that good, but even though it is a lot more difficult to find these good deals, but it works as a great checks and balances, because if you find a deal that cheap, your margin of safety is already built in.
No Perfect Percentage
Everyone has a different threshold when determining what their margin of safety number is. There is not set rule of thumb for determining the perfect percentage because as the deal goes up in value, 65 cents on the dollar is a steal of a deal. It is not about the percentage, it is about you looking at the numbers and then making some pessimistic assumptions. It is looking at a situation and what could go wrong and determining how much money you need in order to have some wiggle room for problems that arise. It also depends on your threshold of profit. For me personally, I look for bigger profits or I don't take the time to mess with the deal, whereas you may be okay with less profits, while still having that margin of safety.
In Conclusion
I hope that this will make a dramatic impact on your investing endeavors, because it can make all the difference in the world between being successful and going backwards. Oftentimes, it's about moving forward slowly rather than always hitting big home runs. It's about being pessimistic about what a property is really worth and what it's really going to cost to fix it up, but at the same time, keeping an overall 30,000 foot view of optimism on your real estate investing business. Margin of safety does not slow you down it just adjusts the way in which you operate. You still make money on them, you're just not making as much money.
My niece is about to lose her home and I wanted to help her out by purchasing the home then selling it to someone else and giving her some money so she can get something else but what kind of contract would I need to do this?
Be sure you know what you are getting in to. Solving your niece’s problem might prevent her from learning a valuable lesson and create a bigger problem for you.
I sent out 280 postcards to homeowners of abandoned houses. How can I get their phone numbers so I can reach out to them to do a follow-up?
The Internet is full of ways to find people; utilize whatever works in your area. Start with a google search.
Mr. Phil excellent video you’re amazing & truly a good person to be giving all this knowledge & tips for free thanks david.
Great video phil. It answered my previous question. You are a real estate genius. Thanks, Tony
Phil
Great Job in explaining and i am just really starting in the Real Estate Market, WholeSaling etc very good tip for me thank you.
Rudy Acosta
Phil Great Job! Everything you stated to be just a little careful when evaluating properties is right on. Always leave some room for that unseen situation. This is how well informed investors play the game.
Thank you for the knowledge.
Charles Dehnert
Hey Phil,
Great teaching. I know you said that there are no hard set rules when building in your margin of safety but is there a general percentage that you would suggest especially on smaller deals of 200k or less?
10% fudge factor
Hi Phil my GURU. Great lesson to learn here. As you said mostly all, right investor knows about 65%on a $ Rule. N The Fixing Cost and twice Closing cost (When I buy and hold for fixing (Holding Cost) and when I flipping to third party) add to the bottom line. This is not all till the property under renovation Interest cost is still ticking and adding to Holding Cost to the bottom line. One have to be really very smart and on his tows. On the other hand once property is fixed and ready to be flipped there I have two scenarios. If I am selling to a Whole seller he will keep at least 20% margin to him self. It means I left with 15 or 10% margin. In 2nd case if I sell directly to end user then I can get away with at least 20% margin. Please Clarify where I am wrong. I will be awaiting. Thanks Phil.
You should sell to retail buyer or, if the property needs tons of work, sell to the type of investor buyer willing to pay more than everyone else. I rarely transact deals with wholesalers; either buying or selling.
Hi Phil: there are these important that are passed unto us, that will make a whole lot if we listen. Thank you for these WISDOM and tip that is very important. I am still will you and studying what is put across. Please answer this question again:
Have you ever done a video on how to create the ARV? Please answer.
Sure. Here it is: Determining Property Value the Right Way
Dear Phil I hope this message will reach you. My name is Oliver Döring. I’d love to be part of your program and I have watched your online program three times and read both of your books twice, watched countless hours of your YouTube videos. I’ve done a subdivision and a removable house project in New Zealand. The only problem is that I’m living in Australia and therefore can’t become a part of your program.
Thank you again Phil. Bye for now.
Hi Phil, I have access to a list of homes for sale by owner/pre forclosed and Im just having trouble figuring out how to get started
Hi Phil. I enjoy all of your videos and feel I am learning much just by watching them. In this video you talked about getting the ARV wrong. I have been looking at properties and seen different theories on how the calculate the ARV. I have used the different methods suggested but I continue to figure higher ARV than the investors I have spoken to say the properties are worth. any where from $10,000 to $40,000.
Have you created a video on how to calculate the ARV?
Hi Phil great video. Can anyone with no experience start up in Real Estate investing?
I would like to get into investing in real estate. I guess the first step is forming llc but some companies say you need a professional to set them up or they are worthless and they want like 8 hundred to 1500 dollars to set it up in Nevada or Wisconsin.Is this right ??Everything with these real estate gurus is to sell me something that is very expensive. I need training but man its expensive. Is there a way to learn the basics so I can try to get going before having to raise thousands of dollars for training?
Take this course, it’s free Creative Real Estate Investing and Flipping Houses
How do you avoid losing money on deals with family member needing to stay in property n then can’t get them out.
Don’t buy deals with family members to begin with.
Thanks again Phil for your great videos and your precious time.we are always constantly learning from you. stay blessed have a wonderful day .thank you
Phil, you are awesome! I really enjoyed this video, especially since I’ve made some of these mistakes myself. I understand about estimated value, but can you give a little advice on how to best determine ARV estimates in order to put in this margain of error on a deal? I’d appreciate it.
This training helps you with further insight into your question: Determining Property Value the Right Way
Always enjoy your information. Thanks for helping us.
What is your golden rule for cash flow properties? I have always tried to acquire properties, that come close to the 12% net after PM, insurance, taxes and maintenance. The properties are usually bought with cash.
Thanks,
JH
Huge Cashflow relative to expenses and instant equity
i had my realestate lic. before so will it be go thing to have before i become i start my working
What are your thoughts about ‘paying’ a tenant/homeowner to not fight an eviction or to move in a timely manner WITHOUT trashing or stripping a home? I’m looking at a couple of pricier los Angeles homes ( $950k +) that were stripped of things like water heaters, sinks, A/C, appliances, cabinet doors and drawers (why, I’m not sure) and I’ve heard of people who’ve paid a tenant to move out rather than fight the eviction process. Some of these homes it would be well worth it to offer the owners $20k (or so) at the close of escrow if they haven’t trashed the thing. When a home has dual A/C at $4k a pop or a missing Viking range, it gets expensive quick.
It’s called a friendly eviction. You can try it. It doesn’t always work. Sometimes the tenants have so much anger, they lash out even though it is not in their own best interest. in my experiences, less than 50% of the time the tenant opts to get some cash in their pocket to move out with a clean property.
Hi Phil, I just wanted say how much I enjoyed your video presentation. I have been in the class room for about 2 years working on getting my first wholesale deal, and I tried so many way to make it happen with no money to help me to close the first deal so that I can get really going. Once again Thank you!!!
Great video Phil! Thank you so much for sharing!!!
I am just not sure where to start? I have no experience !! And vary little money.
Start here Creative Real Estate Investing for Beginners Use the coupon code “freedommentor” to get it for free.
My first foray into buying a house, I came across 2 deals that I passed on cuz I was new to the game and totaling ignorant. A realtor later told me that I would never see deals like them again in my life. I would have had 30-40k in equity on both. How was I to know that was great?!
Become a master at being able to determine property value quickly and accurately.
I love your lectures so much. You inspired and energise me anytime I listen to your lectures. May God bless and keep energizing the Real Estate Investors world.
Best Regards
Real Estate Broker.
Thanks for sharing the info. Mike s.
I agree with the margin of error/safety but I have been margin of safety-ing my way out of getting deals. Either people don’t need to make or don’t care to make as much as I want to make on deals. I assume I will want to sell a propt for under market to sell quick and I over-estimate on the rehab, which leaves me short on offer price. The other people buying are paying stupid prices IMO. This is definitely true only on what I can see which is the MLS numbers. If people want to invest thousands, work for 4-6 mos and then only make $5-10,000 profit, I am not going to be able to compete with that. These are wanna-be investors or perhaps they are looking at it differently.
Good video.
Ken
That is right on. And a smart investor uses those facts to their advantage! FLIP deals to those investors who will pay more than you. Otherwise, avoid competing on deals. Focus on getting to the deal before everyone else.
I am very comfortable will all aspects of managing investment property except I want to know where and how to learn about making offers and the actual paperwork. Especially the contract paperwork. Where do I go to get THAT information. That’s all I need. I don’t need motivation, don’t need to know how to estimate the value of a property, etc. I just need to know Where to FIND the properties and when I do, HOW do I make an offer and what does that look like? Step by Step – more specifically, the paper work and forms involved for my state. Thanks for what you do. It’s very educational and I’m sure many many people are helped by it. Thank you.
A very qualified creative real estate investing attorney can help you with the paperwork. As far as how to make offers, that is an art and it takes a tremendous amount of education to know what offers to make for each individual deal. It can take months for me to fully train one of my apprentices on this art. Certainly it is far too complicated and lengthy for a short video. Finally, as far as finding the best deals, this video sheds light on that: Giving Away Business Secrets
HOW DO I GET MY MONEY WHEN I CONNECT THE BUYER TO THE SELLER
Your closing attorney or title company can answer that wonderful question for you.
Way not by a lot an Build house Lot for $10.000 The builds met $35.000 .I build a $25.000
What kind of home could you build for $25,000? A tree house?
great information . I want to be in your apprenticeship program
Great info Phil…thank you!
I just wanted to say thanks to Phil and Freedom Mentors for posting. I’ve seen about 4 videos so far, and I got to say looks and sounds great. looking at some of the comments attached to those, what I read people enjoyed and use the information put out. I just wanted to ask Phil or anyone else for those whose starting like my self. How does the mentor one on one work for long distance first timers. Once again thanks to Phil and The Mentor Team. See you guys next time.
Almost exactly as if we were in the same town. Phone, email and internet. The vast majority of my apprentices, I have never met in person. In fact, I have several staff members I have never met in person. Gone are the days of having to be in the same room with someone to do business with them.
Phil, thank you so much for this video. All of your videos are great! Pessimism is necessary. Pessimism is not negativity; it is caution. You are an honest real estate investor!
Hey Phil… I love your videos….. and my biggest problem is getting financing for deals… because I have to use a hard money lender who uses either 65 or 70% depending on how risky the flip is… I flipped several houses a few years back… and have been looking for 8 months to get a deal… I lose deals because I have to write in my financing costs???? But I agree with you… I’d rather NOT get it than lose money. I recently lost a deal because I was outbid by $8K and had to write in $11K for hard money???? What can I do besides just keep looking for that ONE great deal to get me started…. Thanks!
Avoid deals that involve bidding wars. It is very, very, very rare that I ever do a deal with a seller who is pitting me against another investor. Go after the deals that no one else knows about. Avoid the crowd.
Thanks again for the good advice. Presently I am looking for a warmer place to live for me and my son. I had a hard winter in KY last year and I am looking south. What is a good southern town with low crime and good schools? Thanks Phil
The South is not known for having great public schools. You’ll have to do some digging on that one 🙂
great video phil. i would be interested to see more of your video library (how can i get to it?). i have had ups and downs in the real estate
market, and so i really enjoyed this very pragmatic and realistic view of real estate investing. it is great advice and i am looking forward to
seeing more videos.
thank you,
david
You can either go to my YouTube channel or take this course, Creative Real Estate Investing. Use the coupon code “freedommentor” to get it for free.
Thank you for the information, there are so many guru’s out there it’s hard to trust.
Thanks again for the video
I thoroughly enjoyed your video Phil. Thank you for the insperation. I am looking forward to learning more
i would like to be one of the investors plse what can i do
i want to invest plot
Phil,
Your videos are fantastic. Do you ever bid on properties at sheriff’s auctions where there’s no way to get inside the property to see its condition? If so, what methodology to you use to build in a safe margin of error? Many thanks.
RARELY. And when I do, I get in the house first, before the auction.
FhilI I enjoyed this video because you previously warning me for future possible problems in the career I have chosen. When I be ready to be in the ground to beginning investing no matter what , maybe, flipping houses or maybe operating like wholesale, I know the I will be a big winner. Fhil I also want to tell you the I’ve been watching your videos for a very long time and I am sure there in this business is not one the offer as many opportunities as you, and for the, reason I will not atop until that I can have you on one by one as mentor and coach,. I also want to say that today I get receive the three main books that you recommend, Because. I’ve been having problems in my computer it was necessary ask to a friend to ordain for me this books (HOW TO BE A REAL ESTATE INVESTOR, REAL ESTATE INVESTING GO BAD AND THE MILLIONAIRE MIND Fhil I want to tell you the because I was not no nothing about computer, when I saw you for the first time on the internet, I had really not noticed the I through the internet I could communicate or reply to you, I promise to you the from now on I will reply all videos the I see.with a lot of respet JulioCesar Olive