Why Warren Buffett Doesn’t Buy Rental Properties

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Coming out of the Great Financial Crisis, Warren Buffett said in a TV interview that if he had a way to buy a few hundred thousand single-family homes and manage them, he would load them up. So have you ever wondered: why didn’t he ever do it?

After all, buying and renting single-family homes isn’t exactly rocket science.

Yes, scaling the business can be difficult, but it can be done, as proven by single-family REITs like Invitation Homes (INVH) and American Homes 4 Rent (AMH), which own thousands of rentals like the one in the picture below :

Rental property investment

Rental property investment (Invitation Homes)

So why did Buffett never build his rental portfolio?

I think this is an interesting question to investigate because actions, or lack thereof, speak louder than words.

If you do some research, you can actually find plenty of clues in past interviews and shareholder letters as to why Buffett isn’t really interested in buying rental properties. In the following, we highlight the top 5 reasons why we think Buffett never bought rentals, and why you probably shouldn’t either.

Reason #1: Understand your circle of competence and stick to it

In the past, Warren Buffett has said many times that the most important criteria for success in investing are to clearly define your circle of skills and stick to it.

You simply cannot achieve above-average success by being a jack-of-all-trades, and therefore it is important to specialize and become an expert in one or a few specific areas.

In Buffett’s case, his first big hits were in insurance companies (think Geico) and consumer goods like See’s Candies, Dairy Queen and Coca-Cola (KO). Later as its holding company Berkshire Hathaway (BRK.B) (NYSE: BRK.A) grew up, he was forced to expand his investment universe and ended up investing in companies like Apple (AAPL) and IBM (IBM). For the most part, however, Buffett has stuck to simple undertakings that he can understand.

Unfortunately, real estate is not one of them. As Buffett’s right-hand man, Charlie Munger, explained at a previous annual meeting:

“We don’t have a competitive advantage over experienced real estate investors… We don’t have any special skills in the area and that means we spend almost no time thinking about it. And then such real estate that we’ve actually owned, I would say we have a poor track record.”

This tells you loud and clear why Buffett is reluctant to buy rental properties, even when they are offered at low prices.

Reason #2: Major economic disadvantage compared to REITs

Buffett’s holding company, Berkshire Hathaway, is an ordinary corporation, which means it is subject to corporation tax on the profits it generates.

At the same annual meeting, Charlie Munger explained that:

“If you operate as a corporation like ours, which is taxable under chapter C of the tax code, you get a whole layer of corporate tax on the income from real estate. That also makes real estate a very lousy for people with our tax system.”

Then Buffett adds that:

“There are other structures that are more attractive. If you’re competing with REITs…you just have an economic disadvantage as a C-corp.”

REITs (VNQs) are publicly traded real estate investment trusts that enjoy a 0% corporate tax rate as long as they meet certain criteria.

By comparison, the corporate tax rate is currently 21% and this is essentially an additional expense that Berkshire would have to face, which would put them at a significant disadvantage.

Could Buffett structure a tax-efficient vehicle outside of Berkshire? Of course he could. But again, going back to reason #1, it’s not his specialty, and his time is probably much better spent focusing on what he does best, which is managing Berkshire.

Reason #3: Extreme management intensity

It’s no secret that managing rental properties can be a huge hassle.

Things will fall apart. Renters can make your life hell. And overall, the financial reward is often not worth it if you take that into account.

Let’s take a simple example.

You buy a property for $200,000 and its monthly rent is $1,500. On the surface, that sounds good. The annual return is nearly 10%! Add leverage and appreciation to that and you get some very solid returns.

But the actual return is actually much lower and potentially even negative.

You see, managing rentals isn’t always easy. In fact, it’s the opposite.

You are constantly dealing with the ugly 3 Ts (tenants, toilets and trash cans…) and the physical structures are always deteriorating, leading to breakdowns.

The 50% rule of thumb says that $1,500 in monthly income turns into about $750 in net operating income, or NOI for short, after you deduct all expenses (property taxes, utilities, management , maintenance, garbage removal, vacancies, etc. .).

So that’s $9,000 in NOI per year, or a cap rate of 4.5%, which is still correct, but not as much as we calculated earlier.

Then, all it takes is one nasty surprise and the yield for the whole year could be lost.

A tenant stops paying his rent and ransacks your accommodation? The roof begins to leak and causes significant water damage? A pipe burst due to the cold? Your tenant is suing you for the mold that made him sick?

These are day-to-day issues you face as an owner, and even at scale, it’s hard to generate strong returns for a company like Berkshire Hathaway.

Reason #4: Less likely to be severely mispriced on the downside

Real estate isn’t exactly a commodity, but it’s closer to being a commodity than a regular business.

Cash flows are much more predictable and the value derived from a property is also easier to determine.

As a result, market values ​​are also more stable and rental properties are less likely to be seriously mispriced most of the time.

As Buffet explains:

“In most conditions it’s tough. It’s a very competitive world. Real estate is priced more accurately most of the time.”

Buffett is a value investor. He achieves above-average returns by targeting investments that are undervalued by the market. It’s easier to find in the stock market because it’s much more volatile and short-term oriented.

This is one more reason why he sticks to equities and possibly REITs rather than rentals. This brings us to our next and final point:

Reason #5: REITs are superior to rental properties

Historically, Buffett seems to have preferred REITs to rentals. From a review of past annual reports, I note that Berkshire has in the past held investments in General Growth Properties, which was later acquired by Brookfield (BAM). He also invested in Tanger Factory Outlet (SKT), Seritage Growth Properties (SRG) and Vornado (VNO).

But his most famous REIT investment is arguably STORE Capital (STOR). Berkshire became their largest shareholder in 2017, then doubled in 2020. Their stake is now worth more than $1 billion.

Why does Buffett invest in REITs instead of rentals?

First, REITs are better investments for Buffett because they allow him to focus on his skill set and let professionals handle rental management for him.

Second, it is also much more tax efficient. REITs are more growth-oriented real estate investments and most of their returns come from appreciation, which is tax-deferred. It is important for a society.

Third, REITs are much more volatile than rentals, which provides attractive opportunities to buy good real estate at a discount. As an example, Buffett doubled down on STOR when it fell more than 50% in 2020. Since then, the stock price has largely recovered, leading to a big gain.

Finally, and perhaps most importantly, because SCPIs are professionally managed and enjoy major competitive advantages, they have historically generated higher returns than private rental properties:

Performance Chart of REITs vs. Private Equity

REIT vs. Private Equity (EPRA)

It’s the average performance, but if you’re selective and know how to sort out the best opportunities from the pack, you can obviously do even better. At High Yield Landlord, our portfolio has grown at nearly 20% per year since its inception:

High Yield Proprietary Performance Chart vs. VNQ

High Yield Proprietary vs. VNQ (Interactive Brokers)

Could we achieve this by investing in rental?

I doubt it, and that’s why I buy REITs instead of leasing, and I suspect that’s also why Buffett tends to favor REITs.

About Robert Wright

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