Certainly, we can all learn a little something from one of the all time great investors. In his annual letter, Warren Buffet looks back at two commercial real estate investments he made. One in 1986 and the other in 1993. Neither is significant in his nearly $60 billion wealth but he believes both accurately reflect his investing philosophy.
The first is a 400 acres farm that he bought outside of Omaha, Nebraska in 1986. In the years prior to his purchase, farm sales prices had skyrocketed. But as it often happens, it was an economic bubble caused by careless banks over valuing properties. The bubble burst and Buffet bought the property for about 50% of what it had last been valued at. Buffet is not a farmer and had no idea what the farmland was actually worth.
How to Value Any Commercial Real Estate
Instead, he valued the property based on what the farm could produce and what the market would pay for the crops grown there. He focused on how many bushels of corn and soybeans the farm was able to produce and what the operating expenses would be. His calculations showed a 10% profit would be realized from a normal operating year. He knew there would be good years and bad years but calculated this to be the average over the years.
However, he also looked at the industry as a whole. He knew that people had to eat and farms would always have a place in the economy. He also understood that farm productivity had a long record of increasing, meaning that output would increase over the years. Additionally, farm produce prices were bound to go up as the population increased. Both assumptions turned out to be true. His investment decision was based on holding long term and recovering his investment cost from profits the operating farm produced. He never took property appreciation into account.
28 years later, the farm is three times as profitable as when he purchased it and the sale value is five times what he paid for it. As Mr. Buffet states it: “I needed no unusual knowledge or intelligence to conclude that the investment had no downside and potentially had substantial upside.”
Another Bubble Pops
In 1993, Buffet purchased a retail property adjacent to New York University. Again, the banks had been overly optimistic about commercial real estate values and had loaned more money than the borrower could repay based on cash flow from the operating business. Buffet was buying for all cash, meaning there would be no loan that needed to be serviced from the cash flow. Similar to the farm, Buffet calculated a 10% annual profit based on the discounted price he could purchase the property for.
Several of the storefronts were vacant at the time and profits would only go up regardless of what these retail shops were rented for. Current occupants were paying $70 each month per square foot. But the largest occupant rented about 20% of the space and was only paying $5 per square foot. However, this tenant was facing a lease renewal in a couple of years and that lease renewal would add substantially to the profit margin. Again, with a current operating profit of 10% there was no down side and a big potential for a large upside in the near future.
Warren Buffet’s investing philosophy is about the value of the operating business. It has nothing to do with where the commercial real estate market value is going. There will always be major swings in commercial property prices. The big secret is finding a profitable business to buy when property prices are low. You’ll always make money with that formula.
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Author bio: Brian Kline has been investing in real estate for more than 30 years and writing about real estate investing for seven years. He also draws upon 25 plus years of business experience including 12 years as a manager at Boeing Aircraft Company. Brian currently lives at Lake Cushman, Washington. A vacation destination, a few short miles from a national forest in the Olympic Mountains with the Pacific Ocean a couple of miles in the opposite direction.