I’m a Warren Buffett nerd. While most people watch series on NetFlix for fun, I like to read through the archives of Berkshire’s Annual Letters! Yeah, it’s that bad.
But if you’re reading this, I assume you’re a little different, too. Maybe you’re proud to be an investment nerd like me!
After all, being a Buffett nerd has its advantages. For one, I learned about the concept of an “economic moat.” It’s a principle that has made Buffett’s investment company Berkshire Hathaway billions of dollars in profits. And it’s become a guiding principle with my own investments.
In this article, I’m going to explain what an economic moat is and why it’s one of Buffett’s core investment tenants. But unlike Buffett, I’m not going to share how to use the principle to buy stocks. Instead, I’ll show how small investors like you and me can build profitable economic moats using real estate investing.
Let’s begin by discussing what an economic moat is.
What is An Economic Moat?
An economic moat protects the profits of a business from attacks by competitors. It’s like a large moat of water around an ancient castle. A business with a wide economic moat has an enduring competitive advantage. This means its competitors have difficulty duplicating it.
For example, one of Buffett’s investments is CocaCola. Around the world, the formidable CocaCola brand creates a competitive advantage. No other maker of sugared water has been able to replicate their success with customers.
Buffett has long used this principle to evaluate and purchase his best investments. The results? $1,000 invested in Berkshire Hathaway at $19/share in 1964 would have been worth 11.6 million dollars in early 2015!
But what does this have to do with you? Should you try to be like Buffett and identify individual businesses with wide economic moats? Even Buffett himself advises most investors to just invest in a broad basket of index funds instead of picking individual stocks.
I’ve found you have to apply this principle more broadly than just stocks or bonds. Economic moats have worked best for me in the world of real estate investing.
Easier Economic Moats Using Real Estate Investing
With real estate investing, your can use your knowledge and skills to make more money investing. For example, you can study every property for sale or rent in a very small area. As the local expert, you can then find properties priced below their full value.
And unlike stocks sold on an exchange with millions of competing buyers, you often negotiate directly with the seller or their agent. This gives you a chance to do even better on price.
But not every piece of real estate will automatically have an economic moat. In the sections that follow, I’ll share five competitive advantages you can look for with real estate investments:
- Pricing power
- Barriers to entry
- Switching costs
- Low-cost advantages
- Trade secrets
Let’s begin with pricing power.
Competitive Advantage #1 – Pricing Power
Buffett’s favorite businesses are able to maintain and increase their prices over time. Their brand and products are unique in the marketplace. This means they don’t have to cut prices to compete.
For example, Buffett has long owned Sees Candy, a specialty chocolate and candy company. Instead of competing on price, Sees has raised prices consistently over the years faster than its production costs.
This pricing power makes a company more profitable over time.
A well-located real estate property works in much the same way. An attractive property in a demand location is unique. Renters and buyers will pay progressively higher prices for the privilege of living there.
I wrote an entire guide on how to choose the ideal investment property location. But within that guide, I included several factors you should look for to find these high-demand investment properties. In summary, you want locations with:
- Increasing demand – This usually occurs with an increase in population and high-paying jobs in your general area. Within micro-locations, you can also find other demand factors like proximity to parks, greenways, schools, and coffee shops.
- Barriers to supply – This occurs from physical restraints (i.e. no more new land to develop) and government restraints (restrictive or expensive development laws). The result is new construction becomes much more expensive and rare, and this also makes existing housing more valuable.
I learned that the properties with the most pricing power are not always the properties you can buy the cheapest. In real estate investing, it pays to follow the lesson Buffett picked up from his long-time partner, Charlie Munger:
It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Competitive Advantage #2 – Barriers to Entry
Real estate investing has inherent barriers to entry. But if you can overcome these barriers, you’ll create strong economic moats.
First, real estate is expensive compared to other investments. You can buy a share of stock for just $100. But even cheap real estate costs many thousands of dollars. This means real estate investors have to either save or borrow money for purchases.
Second, real estate investments require local knowledge. Some principles hold true across all real estate markets, but each local area has its own quirks and unique trends.
Third, real estate has a perceived “hassle” compared to other investments. Many would-be real estate investors sit on the fence because of horror stories they’ve heard about tenants and toilets.
All three of these barriers to entry can be solved with knowledge, systems, and relationships. And the more difficult the better, because that creates an even wide moat. You can invest in real estate stocks, but you won’t be able to build the defensive moat that comes with buying cash flowing real estate.
Competitive Advantage #3 – High Switching Costs
Acquiring new customers is expensive. So, the most profitable companies work to keep their customers for a long time. High customer switching costs help them do that.
High switching costs are anything that makes it harder for a customer to leave. For example, you pay a fee and go through a lot of hassle to switch away from one of the big cell phone companies. This is VERY intentional on their part.
The right real estate can also have very high switching costs. And this can make you a lot of money as a real estate investor.
One of my favorite examples is a real estate investor and teacher from Colorado named David Tilney. David likes to invest in single family houses. He finds that renters of houses tend to stay longer. Often, his tenants have kids and stuff, both of which make it more of a hassle to move (i.e. high switching costs). Small apartments, on the other hand, are much easier to move in and out of. As a result, they also attract more transient tenants.
But David takes it a step further. He looks for what he calls “mouse trap houses.” These houses are loaded with storage, like a 2-car garage, basement, and an attic. What do tenants do? They pile lots of junk in them. Amazingly, the tenants find most other rentals have much less storage, and as a result, they stay with David for 5-10 years on average!
Smart real estate investors can also do more to increase the cost of switching for tenants. Mike Butler, author of the great book Landlording on Autopilot, offers his tenants incentives before each lease renewal. For example, he may give them partial free rent or a property upgrade. By moving, the tenant would now “lose” this benefit, and Mike avoids the costs of a turnover for another year or two.
Competitive Advantage #4 – Low-Cost Advantages
Warren Buffett loves to buy businesses with built-in cost advantages. For example, his insurance company GEICO has always sold insurance direct to customers instead of through agents. This saves GEICO 10-15% in commissions, and as a result, allows them to offer lower prices to customers while still making a profit.
I like buying existing properties (instead of new housing) to give me a low-cost advantage in real estate. New construction material costs tend to rise with the overall inflation level of the market. And as I said in a previous section, local factors like a limited supply of land and government regulations increase the costs of construction even more.
As a result, my existing properties often cost much less than comparable new properties, even after remodeling. This allows me to keep rents much lower than the new construction prices while still making a profit. Not only does this make it easier to keep my properties full, but it also protects me from future recessions or price slumps.
I also like that in real estate investing we can lock-in our biggest cost – interest rates on loans – for very long periods of time. When your rents go up over time (see #1 – Pricing Power) yet your biggest cost is fixed, you have a recipe for a VERY profitable investment over time.
Competitive Advantage #5 – Trade Secrets
The final competitive advantage is a catch-all category called trade secrets. Some businesses develop processes, patents, or new technology that allows them to build enormous economic moats to keep out the competition.
I would have a hard time understanding and identifying the value of these trade secrets with stocks, but in real estate, you can actually develop them for yourself.
Here are just a few ideas of real estate investing trade secrets I’ve used or have seen others use over the years:
- Marketing sources to find deals – Finding good deals is often the most difficult part of real estate investing. But if you can find and cultivate little known or difficult deal sources, you can carve out a strong competitive advantage for yourself. There is also a wide array of online tools at your disposal that can help you out, like a free stock market API, among others.
- Processes & Systems – Real estate investing has long been a local and informal business. If you can bring a degree of professionalism and systems to your small business, you will create a competitive advantage. The Emyth was a book that helped me immensely in this area.
- Relationships/Network – Relationships with people always matter, but with local real estate investments, it matters even more. When you build strong relationships with vendors and other team members, you build an economic moat for yourself. The Speed of Trust by Stephen M.R. Covey opened my eyes to the practical economic value of strong relationships.
- Customer Service – While the real estate itself is typically the focus, how you treat your customers can set you apart from your competition. Be creative and find ways to be remarkable with your service. Seth Godin’s great book Purple Cow can give you inspiration in this department.
- Property Hacks – You can use your creativity and knowledge to improve your profits with real estate investing. For example, you may decide to install tile or other hard surface floors in your rental. It may cost you 20% more now, but it saves you MANY times the cost over the next ten years of ownership. There are many other property hacks like this that give you an advantage.
I’m willing to bet you can find even more trade secrets to make yourself more competitive in real estate investing. That’s the beauty of owning investments that you can personally impact.
Become a Builder of Moats
Warren Buffett has made billions of dollars for a reason. He invests with solid principles, like buying businesses with economic moats. He’s also extremely smart, and he surrounds himself with other smart people like his partner Charlie Munger.
And as a Buffett nerd, I’ve tried to inspire you to model his success. But you don’t have to copy him exactly (although you can always buy Berkshire Hathaway stock). Instead, you can model his principles and apply them to real estate investing. It’s an investment arena that allows you to create and protect your own investing success.
I wish you all the best with your own investing adventures!