Historical article note: This article was originally published on 2019-11-21. Rates, policies, home prices, statistics, product names and qualification standards reflect the environment at that time and may have changed. This archive is for historical record and general education only. It is not mortgage approval, investment, legal or tax advice.
I know Buffett doesn't invest in real estate, and the house he lives in himself is very modest, but the way he runs Berkshire Hathaway is worth all real estate investors learning from. Recently, the WeChat public account "Zeping Macro" published an article titled "Decoding Berkshire: The Way of the Stock God," which detailed how Berkshire's stock price rose from 19 yuan to 300,000 yuan—you read that right, 300,000 yuan per share. If you want Grandpa Buffett to manage your finances, you would need to buy at least one share, which is really unattainable. If I had known earlier that Ren Zeping would write such a research article, I wouldn't have bothered reading those books about Buffett. However, without reading those books, you wouldn't know how precious this research article is; I recommend everyone find it and read it.
The stock price was 19 yuan in 1964. Buying 100 shares would cost 1,900 yuan, and today its market value is 30 million yuan. No real estate investment can achieve this kind of return. So, we must humbly learn from Buffett and see exactly how he achieved such high investment returns.
01 National fortune and personal character
Buffett was born in the 1930s. He bought his first stock at the age of 11, back when there was no liberation yet, and even the fate of the United States was unclear. At that time, the stock market was already the engine of capitalism, but its function was still unstable, and when the engine broke down, it caused the Great Depression. Before 1914 was the golden era of capitalism. World War I made Europe realize the cruelty of war, and the victorious countries desperately tried to suppress defeated Germany, resulting in uneven development, while the Red Soviet Union showed vigorous vitality. After World War I, the United States did not take center stage on the world economic stage, and international trade was still settled in pounds. Between the two world wars, the US and USSR developed the fastest. Once the machinery of World War II was in motion, it stimulated military production. Before the Pearl Harbor incident, the United States stayed on the sidelines and was busy making profits from the war. After being drawn in, the U.S. participated thoroughly, achieving great victories politically, militarily, and economically, and after the war, it reached the center of the world economic stage. As the largest creditor, the dollar naturally rose to replace the pound as the currency for international trade settlement. From 1945 to now, under the deterrence of atomic weapons, there has been no large-scale war in the world. Only one arena remains globally: economic development and wealth accumulation. Warriors, heroes, strategists lost their stage, and wealth magnates appeared under the spotlights. Even Chinese people, who like internal struggles, gave up class struggle and converted to the global unified religion—'regard money as parents.'
Capitalism began experiencing three stages starting from 1876: commodity capitalism, trade capitalism, and financial capitalism. Buffett's investment career started during the era of trade capitalism; the commodity economy had completely replaced the natural economy, imperialism began to decline, colonies were gaining independence one after another, and the number of countries suddenly increased. The world finally understood that what people needed was not world wars, but global division of labor. From then on, world trade embarked on a peaceful development path of 'everyone for me, I for everyone.' Buffett's investment philosophy is to invest in assets with visible returns. So, in his early years, he acquired Berkshire Hathaway, a textile company—a product of the commodity capitalism era. Later, realizing something was wrong, as textiles fell two eras behind entering the financial capitalism stage, Buffett began using the company's corporate shell to invest in the insurance industry, which represents the foundation of modern finance. Using the float from the insurance business as a source of funds, he selected high-quality listed companies, established a value-investing framework, and made long-term investments in industry-leading enterprises with moats. Since President Eisenhower promoted consumerism in 1953, the American people have never changed their original intention: enthusiastic about consumption, eager to shop when they have money, and buy with credit when they do not. Most of the stocks Buffett invests in are consumer goods companies. As long as Americans continue their love of spending, Buffett will likely keep heavily investing in consumer stocks. What he valued in investing in Apple was not technology, but consumption. As assets continued to expand, Berkshire Hathaway not only held high-quality assets by purchasing stocks but also participated in corporate mergers and acquisitions. Today, Berkshire Hathaway has grown into the world's 12th largest conglomerate. Riding the wave of national fortune is much more reliable than chasing trending industries.
After entering the 1990s, Berkshire Hathaway could no longer grow just by buying stocks. So it began corporate acquisitions. There is a condition for acquisitions: integrity and morality must be good, otherwise you will be kicked out like a barbarian at the door. Buffett, relying on his integrity, could acquire good companies even by offering $20 million less than his competitors. Developing this kind of integrity is not something achieved overnight. Those little tricks involving junk bonds for acquisitions, Buffett never used, so he never suffered the catastrophic failures like Milken. Trust is something that has never existed between people, and even less so between companies. Trust, reputation, and credibility are all built through long-term repeated interactions; anyone can do a one-off deal, but considering the benefits of long-term interactions, establishing credibility is still worthwhile. Merchants selling souvenirs in tourist spots know that you may never come a second time in your life, so they basically operate on a one-off game strategy: gouge each customer they can, and if there are many tourists to exploit, why bother with integrity? Long-term investment and long-term strategies are different; you need to be a good person for repeated interactions.
Insights from Buffett for real estate investors:
Cyprus once tried to dress itself up as Switzerland, attracting many Russian tycoons to deposit money there. These Russians' deposits were later converted into bank equity. Depositing money and becoming shareholders—Cyprus is the only place in the world where this happens. Later, the country started bundling passports with real estate sales. I've heard that some Chinese people really dare to buy them, tying their own investments to the fortunes of Cyprus. That's quite an intense taste.
Canada was born during the era of trade capitalism and never experienced the transition from a natural economy to a commodity economy, nor did it ever have a revolution. After the government made some money during World War II, it raised welfare to a high level, allowing later immigrants to start a new life from a high starting point. The biggest advantage of high welfare is that it eliminates the possibility of rebellion by the poor; taxpayers spend money to buy peace, which is worth it. The poor and the rich share the same space, and there is harmony everywhere. Each year, over 200,000 new immigrants arrive, with 115,000 flocking to Greater Toronto, requiring 50,000 housing units, but only 30,000–40,000 units can be built annually. This situation has persisted for 10 years. Investing in Toronto real estate is riding on national luck and stabilized by local trends; in 10 years, housing prices might only double. Although it can't compare to Buffett, modest wealth and peace of mind are enough.
Character is also crucial in real estate investment. Buying a property with cash for investment can double in ten years, with an investment return of 100%. If you take an 80% loan, the investment return is 500%. Whether the bank will lend you money for investment depends on your character: whether you pay enough taxes—if you pay too little, the bank will think you lack repayment ability and haven't contributed to social stability, and will refuse; whether your credit record is good—if you have borrowed money before and didn't repay on time or have a bad credit history, no; whether the loan purpose is honest with the bank—if you promise to buy a property with the loan and rent it to one family, but you rent it to ten families and then come back to ask for an additional mortgage, that's not allowed. Character is not a lifesaver; it cannot save your life. It’s like a health supplement; you should take it regularly even when it’s not immediately needed.
Can you really invest like Buffett just by relying on national fortune and being a good person? That’s a joke. Buffett's investments have two major weapons: leverage and compound interest, one applied to the source of capital, and the other to the use of capital. Let's go through them one by one.
02 Funds Come from Liabilities
Buffett invests without using a margin account. Investing in securities using margin means that an investor puts up 100,000 as margin, and the brokerage leverages it five times, turning the investment into 500,000. If the market price of the securities drops by 20%, the margin is wiped out, and the investor either has to add more funds or cut losses and exit. Some investors say they don't know what margin is, that it was added by the brokerage, so they shouldn't be responsible for the loss. This claim is hard to believe — you put up only 100,000, the investment became 500,000, and you claim not to know?
Buffett did not leverage the stock market; instead, he leveraged outside of the stock market. He started engaging in the insurance sector early on, especially in property insurance and reinsurance. The premiums we pay, including those for home and car insurance, are considered "float" for insurance companies, and the companies only pay out when we make a claim. During the time between paying premiums and making claims, insurance companies can use the float for investments. According to the capital sources in Berkshire Hathaway's annual report, insurance float is the second largest source of capital. The excellent operation of the insurance company continuously provides Buffett with funds. This money is essentially borrowed from policyholders without interest, and if the insurance company is profitable, the effective interest rate on this money is negative. Over the past 41 years, the actual cost of insurance float for Berkshire Hathaway was -2.1%, and in 2018 the total float amounted to 122.7 billion. Buffett's number one investment weapon is: owning the world's largest financial leverage, and it's a self-generated leverage, which, because of its effective operation, has a negative cost. This weapon is no longer a secret. Someone in China tried to play with it, with disastrous results: they attempted to use an insurance company's float to ambush Wang Shi, but ultimately lost due to character issues, being labeled as a "barbarian at the gate" and being banned from the insurance industry.
Ren Zeping's research article extensively introduces the operations of the insurance companies under Buffett. In fact, using "Xue Zhaofeng's Economics Lectures" to understand the insurance industry is the most thorough: insurance companies earn money from market segmentation; the more tailored the insurance, the higher the premiums, and Berkshire does this best. In addition, Buffett's property and casualty insurance company does not use expensive insurance brokers as distribution channels, which is also a winning advantage.
Insights from Buffett for real estate investors:
The source of funds can come from debt, but it's best if the debt is off-balance-sheet, and the lower the cost of debt, the better. The author of 'Rich Dad Poor Dad' has a famous saying: Don’t save, invest. Many people don’t understand, how can you invest without saving? The principle is to borrow money to invest. As long as the returns are greater than the cost of funds, 'borrowed savings' can also be invested. Ordinary people don’t have the ability to leverage on the scale Buffett does, nor can they get leverage at negative interest rates, so their returns cannot be compared to Buffett’s, but this does not prevent us from seeking the help of leverage. A mortgage is leverage that ordinary people can access, and its interest rate is lower than any other type of personal loan. If the return on real estate investment is higher than the cost of borrowing, it is worth trying. Off-balance-sheet leverage is a very important concept; in mortgage terms, it means leverage should be applied to investment properties, not one’s own home, letting tenants bear the debt.
03 The Compound Interest Magic That Never Pays Dividends
The second largest source of funds is insurance float. So, what is the largest source of funds? Berkshire's annual report shows that the largest source of funds is retained earnings.
There are only two tools to get rich: one is leverage, and the other is compound interest. Undistributed profits used for reinvestment are the power of compound interest. Regarding compound interest, there is the Rule of 72, which states that 72 divided by the investment return rate equals the number of years it takes for the principal to double. If the investment return rate is 7.2%, and the earnings are continuously reinvested without withdrawal, the principal will double in 10 years.
Berkshire Hathaway's investors don't need dividends, so they can earn interest. Managing investors' expectations is very important. If investors want current income, Buffett's investment approach isn't suitable. Buffett's approach is to first find investors who don't need current income, then use Berkshire to block the current income. How does this work? For example, Berkshire invests in Coca-Cola and Costco, withholds the dividends distributed by Coca-Cola and Costco in Berkshire Hathaway, and uses them for reinvestment. Berkshire pays corporate income tax but does not distribute it to Berkshire shareholders, avoiding premature profit distribution and double taxation. The price rose from 19 yuan per share to 300,000 yuan per share, meaning the current income was held back for a long time, without tax, and reinvested accordingly.
There are many ways to distinguish between investment and speculation. My favorite definition of investment versus speculation comes from the book 'Where Are the Customers' Yachts?': Investment aimed at making big money with a small amount of money will sooner or later turn into speculation; only investment with large amounts for preservation purposes can achieve ideal investment results. Some people hope that financial advisors can turn a five-figure investment into a six-figure sum in a short period, for buying a house down payment, but it ends up being managed into a four-figure sum. To use compound interest as an investment tool, there are two conditions: no current income; and the principal cannot be used over the long term. One of Buffett’s investment secrets is not paying dividends to shareholders, because only then can compound interest function effectively. His entire life’s work was actually busy with one thing: carefully nurturing the operation of the compound interest machine, continuously reinvesting the profits, not taking the goose eggs, but fattening the goose that lays the eggs.
Insights from Buffett for real estate investors:
When someone invests in real estate, they aim to buy properties with cash flow, but end up choosing a house in a valley. The principle is the same for making a profit in real estate investment: no current income, long-term holding. Take a condo in North York, Toronto as an example: with a 30% down payment, there is cash flow; with a 20% down payment, you need to cover the monthly costs. Is the same house with a 20% down payment a worse investment than with 30%? Quite the opposite. If the bank approves a loan ratio of 80% of the house price, you only need to pay 20% down—but you insist on paying 30%? The temporarily saved 10% down payment can be paid in installments later. If you don't understand the idea that 'investment is a gift to your future self,' chasing current dividends or rental income means you will not do well in either stocks or real estate. If current income is not enough to cover expenses, it's not the investment's problem—it's that you earn too little. Investment is not meant to supplement current income; it is a gift prepared for your future self. Only after retirement do you need current income, because tax rates are lowest then. Real estate investors spend their lives focused on one thing: carefully maintaining the operation of the leverage machine, constantly refinancing, keeping the leverage length, fully using the bank's money to invest, and improving the efficiency of using their own funds.
04 The Power of Value Investing
No matter how low the cost of capital is, if you invest in the wrong assets, it is impossible to achieve good returns. Buffett learned value investing from his teacher Benjamin Graham and continuously refined this investment philosophy throughout his life. When choosing assets, he adhered to the following principles: 1. Analyze the financial condition of the target company to understand its profit model and identify companies with competitive advantages and economic moats; 2. Examine whether the management is trustworthy enough to confidently marry your daughter to them; 3. Buy at a low price when a good company is down on the operating table; 4. Focus on the game without watching the scoreboard, and do not let market fluctuations interfere; 5. Concentrate investments and hold large positions in favored companies; 6. Do not hold stocks that are unsuitable for long-term holding even for a minute; once a stock is selected, hold it long-term; 7. Refuse to subscribe to new stocks.
Insights from Buffett for real estate investors:
Among Buffett's heavily held stocks, financial companies account for 48%, and consumer companies account for 11%, with these two industries making up nearly 60% of his investment portfolio. As we mentioned earlier, we are currently in financial capitalism, whereas previously it was trade capitalism. The U.S. financial industry is a global leader, and the dollar is the global trade settlement currency. Buffett firmly holds onto the two industries that represent the nation's destiny, and identifies companies with moats for investment. For real estate investment, we need to find the world's safest cities, cities that welcome people from all over the world, including refugees, cities with developed financial industries, cities with limited land supply, cities oriented toward high technology, cities that attract international students, and cities that attract multinational corporations… If you look closely, such cities are the ones where housing prices will rise, cities with moats compared to others. Toronto is such a one-in-a-thousand city.
Buffett's idea of concentrated investing is not consistent with the mainstream investment advice today. The difference is that Buffett can read financial statements and dares to invest concentratively. Ordinary investors do not study company reports themselves and only listen to market analysts, so they can only invest diversely. Real estate investment is a type of concentrated investment, with down payments often in six figures, which is quite concentrated, so it requires extreme caution.
There aren't many moments when housing prices in first-tier cities are on the operating table, and at such times, no one dares to buy. Toronto's housing prices are coming off the operating table and returning to normal.
Buffett held stock in The Washington Post for 40 years and has held stock in Coca-Cola and Wells Fargo for over 20 years. The stock price of Coca-Cola did not increase at all from 1998 to 2008, yet Buffett still held it. Some people buy a house and want to sell it after three years; won't they have to pay taxes immediately after selling? In fact, the exit strategy for real estate investment only needs to consider whether the interest rate is higher than the investment return rate. When the interest rate rises above the investment return rate, then you sell; otherwise, don't sell no matter what. If you need cash, take out a mortgage on the investment property. You can recover your invested principal without selling the property. Real estate also has strong liquidity; the key is whether you meet the lender's requirements for a mortgage on an investment property.
Many real estate investors have reaped considerable gains, which actually coincidentally align with Buffett's stock investment philosophy: value investing, concentrated investment, long-term holding, and using leverage to obtain sources of funds.