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.
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.
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
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.
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.
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.
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.
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.
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.