Margin of safety
This is the boundary of error, or the room of error you allow for in the deal, so that if you make a mistake on your estimates or something goes wrong, you have enough margin so that you will not lose money. You’ve covered yourself so that you are still going to make money, even if some added expenses come up.
Author Benjamin Graham wrote a book called, The Intelligent Investor and also acts as a mentor to Warren Buffett, who you might know is the best living equities and business investor in the world. It was Ben Graham that took this idea to the spotlight world of investing advice. The idea that you buy a stock and figure in a margin of safety so that if your estimates of the essential value of that stock are off or something goes wrong causing value to fall, you’d be ok because you figured in a safety net.
Using This Concept in Real Estate
You can use this concept on deals that you close on:
- Buy it with your own cash
- Buy with a mixture of a traditional bank loan and your own down payment
- Get a hard money loan and a down payment
- Get private financing for the entire thing,
- Give the homeowners some money and you catch up their back payments.
- Renovate the home and resell to a retail buyer
- Restore and then rent it out to a tenant
- Do nothing to the property, you’re plainly just going to close on it, because you need to close fast
- An auction
- A wholesaler who is flipping it to you
- The seller just needs cash quickly, and then you’re going to directly resell it on the market
- Any deal that you close on
What’s omitted from this rule? Whenever you are not closing on the deal.
- When you’re receiving a commission
- When you assign your interest
- When flipping a deal
- When you are not putting your own money into it,
- When you’re going to make someone else’s payment
Those types of dealings, this concept doesn’t apply, because it doesn’t matter if you have a margin of safety. You’re not closing on it.
I hope I made that clear. This is for deals that you’re closing on. You need to have a margin of safety. You may be thinking, “Okay, well, what’s the percentage? What should be my margin of safety?” Well, there really isn’t a percentage, per se, because percentages break down. They break down both when the price of the property gets really low as well as when it gets really high. Instead, it’s more of a gut reaction when you look at the numbers.
2 Main Mistakes
Here are the 2 main places I’ve seen where people make a mistake, and therefore you have to have margin of safety.
1. The estimated value. Sometimes they refer to this as the ARV, After Repair Value, but you may not be fixing it up. That’s why I use the phrase “estimated value.”
What’s the property going to be worth that you’re buying, right, or what is it worth that you’re buying?
You have the estimated value. Then you also, that’s the first place people make all kinds of mistakes.
2. The renovation costs. How much is it going to take, how much is it going to cost to get it to this ARV if you’re going to use, if you’re going to repair?
It is a very common thing for a real estate investor to be excessively positive. They think to themselves, “Well, I viewed the comps, and a house down the road sold for this much, but this one could sell for even more.” A lot of investors get overly confident.
On the other side, the same investor will miscalculate how much it’s going to cost renovate. They think, “This will be easy, it just needs some paint there, a little crown molding, to cover up any issues.
Why does this happen, this being optimistic on what a house is worth and how much work it needs? Often it is just a trait of an entrepreneur. We’re optimistic by nature. We see a deal and think “How can this be done? We look at it from the viewpoint of, “We can do this, and here’s how we will.”
That is what is so thought-provoking about the idea of margin of safety, It means that you have to be, the exact opposite. You must be extremely pessimistic about this. You need to view a comp and think, “Well, it’s not going bring in 200 here, because the other house had more square feet, and a pool and mine doesn’t, it is also on a more run down street then the others that sold for more.”
I know it is a strange concept, but being pessimistic builds in the margin of safety. Being Cynical about how much a house will sell for, and being pessimistic about renovation costs. You can even choose to set up a rule for your safety net. Like it will cost 20% more then you estimated for renovations and will sell for 10% less then you are thinking, but that breaks down a lot.
You could look at a deal and think, “I think it’s going to go for 300, but what if it only sells for 280?” Then you estimate renovations and think, “If my estimates say it’s going to cost 20,000 to renovate, based on inspections by my contractor, but what if it costs 30,000?” See what I mean? It’s not essentially a percentage, but you need to build in this margin of safety so that if your expectations are wrong, and these two areas are the most commonly misestimated.
There are many places you can go wrong but these two are the biggest. I’m going to give you an example, a deal I am doing. I had an evaluation at 600,000 on a condo, and everything was going well, and I got it at 375. Still lots of potential for profit and the place didn’t need much work. I had to close on the deal quickly and after closing upon further investigation I discovered that:
1. The condo did not have the right kind of licensing needed to turn it into a nightly rental
2. The condo does not have right of entry to the HOA facilities like the pool or gym.
How did I not see this before purchasing? I read through the HOA docs, and overlooked it until I had already closed on it. Now these two things might not seem like a big ordeal, but it actually ended up being 100,000 difference in value. So now the deal is only worth 500,000 instead of 600,000Thankfully because I had a margin of safety this is not the end of the world but what if I did not have a margin of safety?
Let’s say I was buying the property at, 450 believing it would sell for 600, and then find out its worth 500 because of the two issues we found.
Margin of Safety
Using a margin of safety is how me and my students have continued to be successful every year despite what the real estate market is doing. When the bubble of real estate was burst, we still continued to be successful. We did a lot of short sales, lots of house flipping, but we maintained a margin of safety in our deals. We never took on a deal we couldn’t manage because we always made sure to leave a margin of safety. The best part is that sometimes your estimates are wrong on the OPPOSITE side meaning you spend way less than your original figure which means you make even more money then you had expected.
I watched a great interview with Warren Buffett and Steve Forbes, editor of Forbes magazine. Where, Steve asked Warren a very simple question. He said, “”A lot of people know about value investing and contrarian investing, the concept that you estimate the basic value of a business or a stock, and you hold your fire until it hits the right price to buy it at, but Warren, you’ve been better than anyone else at that. Why are you so much better?”
Warren Replied, “You have to have discipline when you’re making decisions, because at the end of the day, you can be tempted to take a deal, especially if you want to have deal flow.”
Real estate investors, you know what deal flow is. You want to get some deals in the work, you need to get rehabs started, so you can make more money, so you break your margin of safety rules and pick up some deals at a higher price point than you should. I have heard people say things like, “I want to keep the flow going. I just want to retain the whole machine flow,” and so they take deals they should not.
Back to the Forbes and Buffet interview. The interesting thing Warren said was, “You know, for me, a lot of it is not about the home runs I’ve hit. It’s about the deals that I did not lose money on. I either broke even, or did a little better.” He said, “The first rule of investing is to not lose money, and rule number 2 is to not forget rule number 1.” When you maintain a margin of safety, it’s not necessarily that you hit home runs, it’s that you didn’t go backwards, because going backwards can be extremely weakening. Not only disheartening, from an emotional stance, but also from a business stance.
Taking Fewer Deals
When you include a margin of safety in your deals, you’re giving yourself insurance that if your expectations are incorrect, you will still make a profit. It entails self-control, because this means you’re going to pass on more deals. When you start using this concept, you are going to close on fewer deals.
You might be thinking this is a bad thing. When you are searching for deals and making offers on them, you are going to have to apply a margin of safety that will deem many deals unsafe investments. Though, you will be taking fewer deals it also means you are not going backwards, and it means that the deals you do are typically productive. It will force you to think in terms of how to monetize deals, which means you may get better at flipping. You may even get your real estate license to receive commission recommendations.
These are the things I do because I’m very vigilant about the deals I close, the deals that I’m really putting money into, whether it’s my cash or someone else’s. If you’re assuring a loan or if you’re signing on behalf of your LLC and you’re doing the right thing that means that you need to make the right choices on the contracts that you’re closing.
Many people complain about how hard money lenders have a 65 cents on the dollar rule that you need to buy the property at 65% of its value right now at the state it is currently in. Many investors do not like this concept because it’s like, “Where in the world can I find a deal like that?” It is a lot harder to find deals that ideal, but it’s also a good checks and balances too, because if you’re getting deals that inexpensive, you’re already set up for that margin of safety.
Everyone has a different threshold, so I’m not telling you that’s the rule to live by because, as the deals go up in worth, 65 cents on the dollar is a steal, right? It’s not about the percentage. It’s about viewing the numbers and calculating some estimates, then saying, “If I was mistaken here and I was incorrect there, how much room do I still have?” That’s why you won’t find an ideal percentage. For me individually, I look for larger profits or I don’t put in the time messing with a deal, but you may be okay with less profits, still using a margin of safety.
All right, thanks so much for watching. Learn more about us at FreedomMentor.com. If you’d like to learn more about how you can work with us directly 1 on 1 on real estate deals, check out our apprentice program. I’ve also got a great book out there, How To Be A Real Estate Investor, and a ton of these videos. There’s just a treasure trove of videos, with all kinds of great tips that you can dig into as well. All right, I will see you on the next video.