Invest with a margin of safety. Warren Buffet, one of the greatest investors of our time, identifies that principle as one of the cornerstones of sound investing. The principle certainly also applies as much to real estate investing as it does to the stock market. We ignore it at our own peril. Most rehab projects that go terribly wrong do so because there was no margin of safety factored into the deal.
So, what do we mean by a “margin of safety”?
Let’s say for example, a flipper has found a house which (after $30,000 in repairs) could be sold for $200,000. Using the 70% Rule, the most that flipper will offer to pay for this property is $110,000 (70% after repair value = $140,000 – $30,000 for repairs). This offer has no margin of safety so if the house repairs end up running even $5000 over budget that will be coming out of the investor’s projected profit.
And it’s not just about higher-than-estimated rehab costs… it could be that you discover water damage or mold or termites, which totally change your numbers while you’re in the middle of your rehab! If you only budgeted for the best case scenario, this new situation will erase any hope of making money on this deal.
Now, there isn’t a magic formula for calculating a margin of safety. It comes down to examining our estimates. In the example above, how confident is the investor that $30,000 will cover all the needed repairs on their house?
Ask yourself these questions: What’s your personal track record like in terms of accuracy of rehab estimates? Have you often spent more on repairs than estimated? How firm was the electrician’s quote? Look at each estimate you’re putting into your offer. If I wasn’t sure if the electrician could do it for $2000, I might add $2000 as a margin of safety. I’m much more confident that my drywall and painting estimate is solid at $6000, so I might only add $500 of margin there. The less confident I am, the more margin I will add for safety. In this case, the flipper who estimated $30,000 added a margin of safety which brought that number up to $40,000, changing their maximum offer for the property to $100,000.
Most of the time when investors get into trouble on a deal it’s because they’ve poorly managed the deal or poorly structured the deal. They didn’t bother to work in a margin of safety so when the electrician’s work runs $2000 over budget, profit is being lost. If the project was to be completed in two months, but takes three months, that is going to be very costly—especially if there was no safety margin added for the possibility of an extra month of carrying costs.
Adding a margin of safety not just about increasing your estimated budget; it’s is more about increasing the estimates where you have lower confidence or where greater risks are involved. With that margin in place, if things go south you’ll still come out with your projected profit and the ability to repay any lenders. But if things go well, you’ll come out with added profit!
You’ll have to turn down some deals where a margin of safety cannot be factored in. Keep in mind that working without that margin is like tightrope walking without a safety net. Sometimes the risk does pay off. But what about that one time when everything goes wrong? Working with a margin of safety ensures your success. No margin means not having the time to finish the job right. Margin gives you pride in the quality of your work in the rehab. No margin means constantly rushing and working overtime. Margin allows you to finish on time. No margin could mean red ink. Margin keeps you in black ink. No margin causes anxiety. Margin gives you security.
Factor in that margin of safety and you will lower your stress, improve the quality of your work and grow your business.