Warren Buffett is known for investing in equities. Sometimes he even buys whole companies with his investment company Berkshire Hathaway. He does it so well that he has become one of the richest men in the world.
For real estate investments, however, the stock market legend is not popular. There is at least one good reason why Warren Buffett might be excited about real estate as an investment.
What I mean by that
By that I do not mean that Buffett should buy an apartment and then speculate on an increase in value. No, I’m talking about the rental income. But what could Warren Buffett find rental income to be so exciting? The answer provides a key figure that is particularly important to the stock market legend: the return on equity.
It represents the ratio of profit to equity. For example, if a company generates a profit of $100,000 with equity of $1,000,000, the return on equity is 10%. So it sheds light on how profitable a company is.
The return on equity can also be calculated for rented apartments. Suppose a 2-room apartment costs $200,000 including all utilities. To get a bank loan, you will usually have to spend about 15-20% of the total cost yourself, which in this case is equity.
Let’s continue with the 15%. You would have to raise $30,000 of equity for above-mentioned apartment. On the other hand, the rental income minus the interest charge on the loan for the remaining amount. Suppose that the flat throws $550 monthly rent, that would be $6,600 per year. For the loan of $170,000, we expect an interest rate of 2%, which corresponds to an annual interest burden of $3,400.
Of the $6,600 rental income, $3,200 is left after interest, which represents the profit in this case. Now we can calculate the return on equity: $3,200 profit divided by $30,000 equity results in a return on equity of 10.7%. Not bad, right?
Why Buffett still prefers shares
I believe there are two good reasons why Buffett favors stocks and buying companies. First, those who bought Berkshire Hathaway shares in the mid-1960s can now look forward to an average annual return of 21%. That is almost twice as much as the theoretical return of apartment mentioned above.
Warren Buffett is just too good at finding outstanding stocks and companies for a home to yield a return that’s interesting for him. Of course, he prefers to continue to invest in companies that raise liquid funds or buy back shares rather than invest in real estate.
The second point he may not like in the real estate business is the fact that the return on equity calculated above can only be achieved by using as little equity as possible. Doubling the equity in the above example to $60,000, the return on capital employed is only 6.3%.
So, high debt is part of the real estate business if you want to generate high returns on your invested capital. And high debt can thus not stand Buffett times! Considering these two aspects, I think Buffett will not be entering the real estate business on a large scale in the future either.