Following the Margin of Safety Rule
When it comes to investing, arguably no one has been more successful than Warren Buffet. When asked how he has consistently done so many profitable deals, he claims to follow two rules:
Rule #1 - Don’t lose money
Rule #2 - Remember rule #1
Sounds pretty simple and rather obvious but how do you actually do deals; in our case real estate deals, and not lose money? Warren Buffet’s mentor Benjamin Graham, taught a principal that Warren Buffet lives by called: “The Margin of Safety.”
It means when doing a deal, you build in extra room (margin) in case the return on investment isn’t as expected. Warren Buffet once said:
“You leave yourself an enormous margin of safety. You build a bridge that 30,000-pound trucks can go across and then you drive 10,000-pound trucks across it. That is the way IO like to go across bridges.”
When it comes to doing real estate deals there are two primary reasons that investors don’t follow the margin of safety rule and lose money...
1. Over estimate the value the property
Whether it’s buying to flip or buying to rent, most investors are overly optimistic about the estimated value of the property.
2.Under-estimate the cost of repairs
When it comes to the cost to make necessary repairs, most investors under-calculate how much it’s going to cost. Without having a margin of safety, the deal can quickly lose money. For example, If you go into a fix and flip deal expecting to make $15,000 net profit and the property sells for $10,000 less than you expected and the rehab goes over $10,000, you just lost money! The reason why I’ve consistently made money on deals is by having a solid margin of safety, which means that the occasional bad deals just didn’t make as much as I’d hoped (instead of losing money). On the few instances where I did lose money it was for the 2 reasons cited above and ultimately because of not having good margins of safety. Currently, I have several finder fee programs where I pay investors for bringing me deals that fit my criteria. Occasionally, a student in the program gets upset when I turn down his or her marginal deal. I follow the standard 65% formula, which allows for the ideal margin of safety and cringe at the thought of them actually investing their own money (or borrow someone else’s money), to do that sub-par deal. So, what does it take to put into practice the Margin of Safety rule?
Discipline: You have to be willing to walk from deals. It means you have to work harder to find good deals. It means making more offers and ultimately doing fewer deals. However, here what I believe: It’s better to do fewer deals with higher profit margins than doing more deals with lower profit margins.
Non-Emotions: You have to learn how to leave emotion out of the equation. Look at the numbers only. Don’t get excited about how much you love the house. I hear investors say, ”It has so much potential…” Who cares! What are the numbers? Be realistic, stick to the formula, build in a margin of safety and be willing to walk from the deal. Do that and you might just become Warren Buffet someday.
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Until Next time,
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