Margin of Safety — A crucial conservative principle

If I had to pick one of the paramount principles of conservative real estate investing, it would have to be the margin of safety. More than an individual concept, the margin of safety is a state of mind that encourages us to think about and therefore plan for what’s the worst that could happen. We call that manner of thinking “worst case scenario” investing. Allow me to explain.

When starting out, most investors tend to be very excited about the process of investing that sometimes they lose sight of what is the true goal of investing: Success! And don’t confuse success with money either. Simply, money is the means to succeed at whatever ultimate goal(s) you are pursuing. It could be financial freedom, or a college fund for your little one, a better investment alternative to the stock market, or good old wealth building. And if you are going to succeed, you must create a plan that accounts for all those bad things that might happen during real estate investing. For instance, let’s say that you are estimating a total repair cost of $10,000 for a particular property. What happens if there are unexpected plumbing problems that you need to address? Or what if your home needs an additional coat of paint? These are items that must be accounted for in your analysis by “padding” your estimates with an additional amount (15-20%). What if the house doesn’t sell for full price but it sells for 5% less instead? You have to run your numbers and ensure that the deal still makes sense. Don’t get me wrong:  These things might never happen in a particular deal and that just  means you  increased your profits or cash flow.  But if your deal relies on these issues not happening, then you might be walking on thin ice.

Accounting for unexpected items, which we refer to as having a margin of safety, is a crucia step to conservative real estate investing.  Remember, if you make money in the worst case scenario, you will definitely make money in the best!

On a side note, you don’t want to over account for unexpected items as this may leave you right out of good deals. But when applied within reason, this principle  will establish a conservative discipline that will serve you well on the long run.

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Also Read:  Conservative Real Estate Investing: A Guide