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Is Real Estate a Gruesome Business?
Warren Buffett defines a “gruesome business” as one that requires a lot of capital and produces a low rate of return. Is real estate gruesome? Let’s see:
- Does it “require significant capital to engender … growth” (WB, 2007; PB p. 14)?
Yes. The median home price in America is about $220,000. The average rent is about $800/mo. So a home costs almost 23 years in rent. That’s a lot just to get started.
A previous article talked about how potentially $1,700/mo can be spent just on maintaining a $250,000 property. As a percent of rents, that’s definitely a lot.
And once your house is full, you can’t get much more revenue except by buying another house.
- Is your house more like a candy bar or a cup of sugar?
Warren writes (1982; PB p. 15), “[Differentiation] works with candy bars (customers buy by brand name, not by asking for a ‘two-ounce candy bar’) but doesn’t work with sugar (how often do you hear, ‘I’ll have a cup of coffee with cream and C & H sugar please’).
Every house has a little bit of “candy bar” to it, since it’s so rare that any two apartments look and feel the same. But every house also has a little bit of “sugar” about it when customers are looking for “off street parking, laundry, two bedrooms.” I think most apartments are more sugar than candy bar.
- Do you feel real pressure to be “the lost-cost producer” (2000; PB p. 15)?
How many of us landlords have reputations for being big spenders? That’s right, none.
All this doesn’t mean you can’t make money in real estate, but it does mean you need to be very careful. Here are some tips:
- Watch that purchase price. Don’t pay too much for a rental property.
- Work hard to differentiate. Make your ad glossy and your apartment smell good.
- Keep costs down. Shop for insurance every year, refinance if you still haven’t, and spend money on projects that will save money over time, like good rain water management, durable surfaces, and upgraded plumbing.
The Warren Buffett quotes in this article come from his “A Few Lessons for Investors and Managers,” edited by Peter Bevelin.
Financial Figuring for Landlords: Real Estate Moats
A moat was a medieval form of security. Just pull up the drawbridge and watch as your enemies fail to get across the water, or if they do, to scale the wall of your castle. Although physical moats have no place in modern real estate (can you imagine the lawsuits?), an “economic moat” is Warren Buffett’s choice metaphor for what makes a business resistant to competition. Real estate as a business has a few good economic moats.
First of all, it’s very expensive for a tenant to change their real estate provider. This is called “high switching costs.” Think about the search for a new apartment, giving notice, cleaning and repairing the apartment to get a security deposit returned, moving all that stuff, and unpacking it all on the other side. This could take days, and if some of the security deposit is withheld or a moving company is hired, it could cost hundreds of dollars on top of that. This means that a rational consumer of rental housing will grudgingly accept any rent increase below their moving costs. That’s good for your business.
The second moat is the potential to be the low cost provider. A lot of real estate businesses are run suboptimally. They’re saddled with high debt, old equipment, and bad rental agreements. A business run with reasonable debt, reliable equipment, and good tenants (or else, good conflict negotiation mechanisms) can operate at a lower price than average. This helps you get the best tenants and keep them, translating into lower turnover and lower vacancies, both good for business.
The third moat can be location. Although I poo-poo’d it in my last column, saying that price mattered most of all, location can be a valuable intangible asset. You might reasonably pay more to acquire a property on a public transportation route, for instance, because it makes your property more desirable to prospective tenants. Once you have it, this kind of benefit is hard for competitors to replicate.
So the next time you think your rents are a bit low, or you paid too much for a property in a prime location, remember that these moats may be contributing to your economic success. On the other hand, a little rent raise probably wouldn’t hurt, either.
