Earlier this week my father sent me this article containing an excerpt of Warren Buffet’s upcoming shareholder letter. His annual letter—which started in 1965—is well known in the investment community. And in many ways, it’s like his own annual blog, started well before anybody knew what a blog was. His letters are personal, genuine and engaging—just like a good blog should be.
But for me, what was really interesting about the letter is that it provided a number of lessons about investing in real estate. Lessons which, in my view, really represent the fundamentals of the business. The way I think about it is that there are really 2 ways in which to make money as a real estate investor over the long term. You can develop/reposition real estate and/or you can collect rent.
If you’re developing or repositioning real estate, it means you’re doing something to increase the value of the property. It could be by rezoning, building new, or through an aggressive leasing strategy. It’s whatever you believe will unlock additional value. Once you’ve done this, you then either sell the property or you move onto the 2nd way of making money in real estate.
By collecting rent, I really mean that you’re buying yield. This means you’re saying to yourself:
I can buy this property for $1,000,000 and the net operating income on it is $100,000 (per year). So that means I’m buying at a 10% cap rate (or return).
Or maybe you’re saying:
I can buy this property for $1,000,000, but the net operating income is only $25,000. However, the rents are well below market and I think I can easily get this thing up to a “10 cap.”
Either way, you’re buying a stream of cash flows and you have an understanding of where that cash is going to come from.
If on the other hand, you’re buying solely on the expectation that prices are destined to rise, you are—as Buffet points out in his letter—speculating. You’re not doing anything to create value and so you’re not developing. And if you’re counting on price growth to generate your investment returns, then you aren’t buying yield either.
While many people have made large sums of money by speculating on real estate, I don’t consider myself capable of doing that in any sort of sustainable way. Hell, if Warren Buffet doesn’t think he can do that, why should I think I’m special.
But some of you may disagree with this framework. If so, I’d love to hear from you in the comment section at the bottom of this post.