Buffett: Real Estate Taught Me How to Invest

February 25, 2014

In his annual letter to shareholders, billionaire and Berkshire Hathaway CEO Warren Buffett talks about how two small non-stock investments in real estate from years ago were keys to teaching him about investing. 

Buffett says in the letter that in 1986, he purchased a $280,000 400-acre farm about 50 miles north of Omaha, Neb. From 1973 to 1981, the Midwest saw an explosion in farm prices, but then the bubble burst and prices declined up to 50 percent or more. That's when Buffett decided to buy. 

"I knew nothing about operating a farm," Buffett writes. "But I have a son who loves farming, and I learned from him both how many bushels of corn and soybeans the farm would produce and what the operating expenses would be. From these estimates, I calculated the normalized return from the farm to then be about 10 percent. I also thought it was likely that productivity would improve over time and that crop prices would move higher as well. Both expectations proved out. I needed no unusual knowledge or intelligence to conclude that the investment had no downside and potentially had substantial upside. There would, of course, be the occasional bad crop, and prices would sometimes disappoint. But so what? There would be some unusually good years as well, and I would never be under any pressure to sell the property."

Now 28 years later, Buffett says the farm has tripled its earnings and is worth five times or more what he originally paid for it. 

He also talks in the letter about another key small investment he made in 1993: a New York retail property adjacent to New York University that the Resolution Trust Corp. was selling. He made the purchase just after the bubble had burst in the commercial real estate market. 

"Here, too, the analysis was simple," Buffett writes about purchasing the property with a small group of investors. "As had been the case with the farm, the unleveraged current yield from the property was about 10 percent. But the property had been undermanaged by the RTC, and its income would increase when several vacant stores were leased. Even more important, the largest tenant — who occupied around 20 percent of the project's space — was paying rent of about $5 per square foot, whereas other tenants averaged $70. The expiration of this bargain lease in nine years was certain to provide a major boost to earnings. The property's location was also superb: NYU wasn't going anywhere. ... Annual distributions now exceed 35 percent of our initial equity investment. Moreover, our original mortgage was refinanced in 1996 and again in 1999, moves that allowed several special distributions totaling more than 150 percent of what we had invested."

Buffett says he uses the two stories to teach fundamentals of investing, such as the importance of focusing on the future productivity of an asset and its prospective price change. 

"My two purchases were made in 1986 and 1993," he writes. "What the economy, interest rates, or the stock market might do in the years immediately following — 1987 and 1994 — was of no importance to me in determining the success of those investments. ...  A 'flash crash' or some other extreme market fluctuation can't hurt an investor. Indeed, tumbling markets can be helpful to the true investor if he has cash available when prices get far out of line with values. A climate of fear is your friend when investing; a euphoric world is your enemy."

Source: "Buffett's Annual Letter: What You Can Learn From My Real Estate Investments," Fortune (Feb. 24, 2014)

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