Buy Like an Investor: Answering the Most Important Real Estate Question

Making successful decisions as a property owner is a complicated task.

It seems simple enough. Buyers should, "buy low, sell high" and always seek the best "location, location, location..." Yet invariably, at the end of each market cycle overwhelming numbers of property owners are left in an unfortunate and losing position.

Information and guidance can also be confusing or disheartening.This past month senior economist Paul Dales, expressed his belief that "There's no denying that home sales are still very low and will remain low for a few years. But after having risen in each of the last three months...it is clear that a housing recovery is now well under way." A week later David Blitzer, chairman of the index committee at Standard & Poor's explained, "Despite continued low interest rates and better real GDP growth in the fourth quarter, home prices continue to fall... "The trend is down, and there are few, if any, signs in the numbers that a turning point is close at hand."

It's no surprise that many potential home buyers and sellers are left dumbfounded when it comes to making a sound financial decision. Throughout the years, regardless of market conditions or level of experience there remains one most important question that all existing and potential property owners should answer before making a move.

How do I make a good buy today?

Over the course of my 19 year career, the answer to this question has changed fluidly depending on where opportunity lies and to whom I'm giving the advice.  Yet, beyond the specifics relating to each property, the true answer remains the same:

Think and buy like an Investor.

Distinguishing Between the Investor and Speculator

To understand this principle it's first important to distinguish between the investor and the speculator.

A real estate investor is an individual or entity that invests equity into a real estate asset for the purpose of generating income from or adding value to the existing improvements.  Investors can have long term or short-term strategies. They may use their own capital or they may borrow (leverage) equity to varying degrees. Some create value by curing defects either physical (dilapidation) or financial (cash buyers with quick closings), while others employ long-term hold strategies that gather value from timing and appreciation.

Speculators can share timing and leverage strategies with investors, yet that is where the similarities end. The intent of a speculator is not to add value to the economic engine; rather they look to take advantage of the marketplace by simply getting in line first. The speculator is driven by greed and looks to horde or corner markets intending to reap exceptional short term profits before quickly exiting the marketplace without regard to what is left behind.

True real estate investors deliver equal value to the market in return for their profits. Thinking like an investor allows home buyers to couch the value of their investment against their needs and desires.

The Intelligent Investor

Warren Buffett is widely considered to be one of the most astute and successful investors of all time.  In one of his more popular quotes he attributes his philosophies as being 85% Benjamin Graham.  Graham was a mentor to Buffett early in his career, considered one of the most astute investors, and wrote the highly regarded investment books The Intelligent Investor (1949) and Security Analysis (1934). In those books Graham lays out three timeless investment principles which continue to guide the most successful minds in the investment business.

Principle #1: Know what kind of Investor you are

In Graham's words, "Work = Return."  Knowing which type of investor you are means understanding if you are willing to take an active/enterprising role or passive/defensive role in your investment strategy. An active investor puts in the work to discover the untapped value of a particular investment by researching and discovering potential for growth. A passive investor finds market tested, blue chip opportunities thoroughly evaluated by the market and other investment minds.

In real estate an active investor seeks higher returns by seeking out undervalued property.  Bank REO's and short sales may fit this strategy.  Further, "fixer-uppers" and homes in "emerging markets" require more legwork from the buyer.  It can lead to large profits, however the time and energy needed to be successful and happy with an active investment may not be available or suitable to everyone. Some home buyers prefer to find neighborhoods which have long standing appeal, houses in immaculate or move in condition, and homes lovingly tended to by owners who can meticulously walk through each detail of your potential purchase.

While the latter strategy may not have the same potential for large swings of profit, it also carries with it less volatility and potential for loss. Knowing how much time and effort you are willing to put into your housing investment and your tolerance for risk should guide you in your search.

Principle #2: Always invest with a margin of safety

The simple idea behind this principle is to minimize risk buying assets at a discount to their intrinsic value. The goal would be to buy $1.00 assets for $.50. In real estate this means valuing investment properties based on existing or actual income rather than fabricated or scheduled income. For home buyers it can also mean finding a home priced below its replacement value. The burden of a monthly mortgage payment becomes much heavier in trying times.  Appropriately sizing your price range and sticking to your budget will greatly increase your chances of success.

Principle #3: Expect volatility and profit from it

The market will fluctuate, and sometimes wildly. Rather than fearing volatility, use it to your advantage to get bargains in the market or to sell out when your holdings become way overvalued.

Mr. Graham illustrates this principle with a well know parable about an investment partner named "Mr. Market."  Mr. Market is the imaginary partner of every investor and each day Mr. Market is willing buy or sell your shares of an investment at a price determined by his wild mood swings. Most days Mr. Market's price is fair and makes good sense.  However, when he's optimistic his offer price can be ridiculously high and when he sees gloom and doom his offer price becomes absurdly low. In each case you, as a rational investor, have the opportunity to make your transaction decision based on your own analysis. The opportunity is to reap the rewards of buying when Mr. Market's fear cause him to sell in a panic and realize profits when Mr. Market's unbound optimism cause him to grossly overvalue your shares. Opportunity in the real estate market comes from applying rational analysis against the irrational emotions of the marketplace. Look for signs that Mr. Market is being led by emotions when determining his price.

The Bottom Line

While the concept of buying real estate for profit is not that complex, making the decisions that lead to that success can prove a bit more involved. In order to make smart decisions, home buyers today must understand their tolerance for risk, plan for unexpected surprises by building in a margin of safety, and prepare themselves to act when opportunities present themselves.

Market conditions will continue to fluctuate but the principles of successful investing remain steady.