What does Berkshire Hathaway have in common with Real Estate Investing?

What does Berkshire Hathaway's investment strategy have in common with real estate investing?

There are a lot of “millionaire next doors” who have created significant wealth in real estate. Charlie Munger, Warren Buffett’s right hand man, started his career as a real estate attorney.

Munger made his first million in real estate. His second largest holding after Berkshire Hathway is multifamily real estate.

Both investments are “carry trades on positive cashflow depreciable assets secured by (fixed-rate) permanent financing”. That’s a mouthful.

What does that mean? Here's the breakdown:

Carry Trades: In the world of finance, a carry trade is a strategy where you borrow at a low interest rate to fund investments with potentially higher returns. In the context of real estate, this means taking on a mortgage with a fixed-rate (the low interest rate) to buy a property (the investment with potentially higher returns).

Berkshire is borrowing $122 Bn using its AAA rating to finance cashflowing assets.

Berkshire captures the spread *and* benefits from the depreciation from acquiring the business.

Private equity real estate investors with access to low-cost financing benefit from the same dynamic. Blackstone’s “Invitation Homes” (since exited) is the real estate analogy to what Berkshire is doing.

Positive Cashflow (and Float): A positive cashflow indicates that the income generated from the property (primarily through rent) exceeds the costs associated with owning and maintaining it, including the mortgage payments, taxes, and maintenance expenses.

This provides the investor with a steady stream of income. That income can be deployed to take advantage of dislocation.

Buffett is serious when he says he likes to see stock market prices drop - he always has cash on hand from his ‘high return-on-equity’ portfolio and insurance float to take advantage.

In real estate, the ‘float’ is the income generated from the real estate portfolio.

Depreciable Assets: Real estate properties are considered depreciable assets, meaning their value is expected to decrease over time due to factors like wear and tear. The tax code allows real estate investors to depreciate the acquisition price over 27.5 years.

Berkshire Hathaway takes advantage of a similar concept - goodwill amortization - when they acquire a company.

The depreciation creates a ‘tax shield’. Berkshire, or the real estate investor, can enjoy positive cashflow but shield a portion of that cashflow from taxes.

Dislocation: Buffett benefits from market dislocation. In October 2008, he acquired interest in large banks. Similarly, as recently as Q4 ‘22, he added to various positions.

Real estate is also cyclical. The best time to invest is when interest rates are high, vacancies are elevated, and overly-aggressive real estate operators have experienced cost overruns and cannot refinance their debt. This combination of factors means the prices of assets are low.

Similarly, Berkshire is a provider of rescue capital of last resort. Buffett has access to cheap financing. And Berkshire always has cash on hand thru the raw cash generating power of its holdings to make a deal.

Portfolio Offsets: Berkshire owns 80+ portfolio companies. Many of these companies are generating passive income. Many of these companies also need additional investment (‘capex’).

Buffett can choose to make investments in a franchise and depreciate the investment. The depreciation helps to offset the income generate from other investments.

The same strategy works in real estate. Real estate investors can purchase rental properties and make capital improvements. The depreciation expense from these upgrades can help offset rental income, reducing taxable income just like at Berkshire. Owning a portfolio of real estate allows investors to strategically balance capex and depreciation to maximize after-tax cash flow, similar to Buffett's approach with Berkshire's operating companies.

Fixed-Rate Permanent Financing: The mortgage on the property typically has a fixed interest rate, protecting the investor from potential rises in interest rates.

Berkshire Hathaway's investment strategy is fundamentally similar to the real estate investing model described above. The company, under the leadership of Warren Buffett and Charlie Munger, borrows money at low interest rates (through insurance float) to invest in businesses that generate steady, positive cashflow. Just as depreciation offers tax benefits in real estate, Berkshire Hathaway also takes advantage of depreciation and other deductions to minimize its tax liability.

Moreover, just like fixed-rate financing provides predictability in real estate, Berkshire Hathaway also prefers businesses that have predictable earnings. Its investments often have a "moat" or a durable competitive advantage that protects its cashflows, much like a well-located property with long-term tenants provides consistent income.

Conclusion

In essence, the principles guiding Berkshire Hathaway's investment strategy — focusing on positive cashflow, understanding the power of leverage, and recognizing the tax benefits of depreciation — are the same principles that have created real estate “millionaires next door” for many.

Therefore, the intersection between Berkshire Hathaway's approach and real estate investing is not coincidental, but rather, a testament to the enduring value of these fundamental investment principles.