Stewart Hsu

Warren Buffett is the investor’s investor. He’s arguably the most successful investor in history, the Tiger Woods or Michael Jordon of the investment world if you will. His company, Berkshire Hathaway has achieved a stunning 21.1% annual compounded rate of return over the last 43 years.

$100 invested in Berkshire in 1965 would be worth over $310,495 in 2008. Einstein said “the most powerful force in the universe is compound interest,” and it shows.

Perhaps what is most remarkable and most telling is the consistency of results over such a long period of time. Warren was born to invest, he’s been a student of it since he was 11. Charlie Munger, Berkshire’s Vice-chairman, calls Warren “an incredible learning machine”.

I’m reading The Essays of Warren Buffett: Lessons for Corporate America, which is essentially a compilation of Berkshire’s annual reports organized by topic, i.e. Corporate Governance, Corporate Finance & Investing, Mergers & Acquisitions, Accounting & Valuation, etc. As a fellow investor, I’m always looking to learn and expand my knowledge and this book is truly packed full of practical, insightful and easy-to-understand investing wisdom that applies not only to securities/companies but all investments in general.

Warren Buffett’s Most Important Investment Advice: Margin of Safety

Buffett learned the art of investing from Benjamin Graham as a graduate student at Columbia Business School in the 1950s and later went to work for him. Buffett highly recommends people read Graham’s “The Intelligent Investor”; he reiterated this suggestion at the 2008 Shareholder Meeting this year. In the final chapter of that book, Graham states “Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety.” Upon which Warren remarks, “Forty-two years after reading that, I still think those are the right three words.“

The principle is that one should not make an investment unless there is sufficient basis for believing that the price paid is substantially lower than the value being delivered. This advice may sound obvious, even a bit trite, but how many of us actually follow it in practice? It’s another way of preparing for the unexpected. And if you look at Warren’s results over 42 years of conscientiously applying this idea, we will all do better with our investing by keeping in mind these 3 simple words: Margin of Safety.

As an investor, you need to be able to see the “forest for the trees” and you need to be aware what’s going on at a macro-level. Following are some interesting data points to help put into perspective where we are in the U.S. economic and apartment market cycles.

Larry Souza, a Managing Director with Charles Schwab Investment Management, published a report 7/29/08 titled “Commercial Real Estate: Economic Cycle Analysis.” Heavy in the economic-speak, I had to read it a few times to pull out these take aways for you. Following below are what I believe are the salient points of that analysis, slanted towards your writer’s choice of real estate, i.e. apartments.

First, as background, it’s important to know the report is based on data from Standard & Poor’s/GRA Commercial Real Estate Indices (SPCREX). The SPCREX is composed of 10 indices, namely 5 geographic regions, 1 national composite and 4 property sectors. These indicies measure the change in prices. Unfortunately, they do not cover Texas as a region (perhaps it’s because TX a non-disclosure state?), but they do track “Apartments” as one of the sectors. Per the S&P factsheet, the SPCREX is “designed to be a reliable and consistent benchmark for commercial real estate prices in the United States.”

For context (and as trivia for you to impress your real estate associates), the estimated value of all direct commercial real estate in the U.S. is $5.3 trillion, of which apartments make up $1.3 trillion of 24% of the total.

Larry Souza’s Findings

1. Since 1993, commercial real estate has gone through 2 full cycles.
2. Most of these indicies in the prior commercial real estate cycle peaked around May-Jun 1999 (avg +14.5%), and troughed around May-Jun 2001 (avg -1.2%). Apartments peaked Jun 1999 (avg +14.6%) and troughed in Apr 2001 (avg -2.0%).
3. Compared to the recent cycle, most indicies peaked around May-Aug 2006 (avg +16.3%) and troughed between Oct 2007 - Apr 2008 (avg +1.7%). Apartments peaked Aug 2006 (avg +16.6%) and troughed in Jun 2007 (avg -3.5%). Note: it has yet to be determined if the current cycle has hit bottom.
4. For the prior apartment cycle, it took 22 months to decline from peak to trough.
5. For the current apartment cycle, it took 11 months to decline from peak to trough.
6. Growth rates for national commercial real estate prices are moderately correlated (but statistically significant) with total non-farm employment growth rates. For those statistics-savvy, the Multiple R value was 0.27 for the apartment index to total non-farm employment.
7. Overall, the SPCREX indices appear to lead the troughs and lag the peaks of the overall business cycle. So, in plain English, I understood this to mean the indicies will indicate the bottom of the business cycle in advance of it actually happening… which is potentially very useful! This one idea, is the gem in the whole report, as it would provide some data that the economy has stopped declining and is back on the rebound. Also, the indices would not indicate a peak has been reached until after that has happened (don’t see as much value here, other than to be very cautious if you continue seeing it rise for extended periods of time).

Apartment Cycle Charts

A picture’s worth a thousand words, so I took the data available on the S&P website, and threw it into a chart. Here’s the “2 Cycle Apartment” chart which covers the Apartment Sector index from Oct 1993 thru Apr 2008.:

Given this prior chart covers 2 cycles and 15 years, I wanted to see what it would look like if we just went for 1 cycle over 7 years. I inserted a trendline to get a sense of where we currently stand. Here is the “1 Cycle Apartment” Chart, i.e. the apartment Sector index from Apr 2001 thru Apr 2008. Similarly, I inserted a trendline.

So, is it time to buy or sell? Only time will tell.

For all you data die-hards out there, here’s are a couple links, one to Larry’s report, and the other to S&P’s SPCREX website.

According to the National Apartment Assocation (NAA)’s Units July 2008 issue:

“Sales of apartment communities dropped significantly in April as fewer than 100 properties sold for $5 million or more, according to Real Capital Analytics’ April report. Volume in April totaled $1.2 billion, just 30% of the levels averaged in the first three months of the year. Compared to a year ago, property sales last month represents an 81% decline.

New offerings were also down from March, but only by 25%, resulting in nearly $4 billion more listings than closings. So far this year a total of $23.2 bilion of apartments have been put up for sale but only $13.7 billion of properties have sold.”