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)