“Confronted with a challenge to distil the secret of sound investment into three words, we venture the motto, Margin of Safety.” Benjamin Graham in The Intelligent Investor, 1949
Ben Graham was Warren Buffett’s most influential investing mentors. His concept of the “margin of safety” changed the way Buffett (and countless others) thought about investing. As he said:
“Forty-two years after reading that, I still think those are the right three words.”
But what is the margin of safety? What does it have to do with buying and financing properties? And does it only apply to property investing? (Hint: the answer is no).
In this article, we will answer all these questions. We will explain the simple idea behind this concept as well as why and how you can apply it to the realm of properties (even if you’re not an investor).
The Simple Idea Behind the “Margin of Safety”
If we boil the concept of a margin of safety down to its very essence, we would be left with a single word – buffer. As applied to stock investing, the idea is to only buy a stock when its market price was lower than its intrinsic value. The difference between the two was the margin of safety – a buffer that can better protect you in an unknowable future. The higher the margin of safety, the less accurate you had to be about the future.
It’s not necessary to get into the intricacies of estimating the intrinsic value of a stock here. But what is important is understanding the core idea behind having a margin of safety and why it matters when buying properties.
Why Having a “Margin of Safety” Matters When Buying a Property
Since margin of safety originated as an investment concept, let us first look at how it applies to buying property. The easiest way to apply this concept there is by comparing the net rental yield of a property with the mortgage rate. Obviously, you want the net rental yield to exceed the interest rate, but by how much?
That “how much” is your margin of safety. We say “your” because there is no one-size-fits-all answer. Your personal circumstances will dictate what you are comfortable with and what you can bear.
But why do you need that margin of safety? Well, remember that although interest rates are low now, they won’t stay that way forever. And there are other ways that your mortgage costs may unexpectedly change. That margin of safety is there to protect you against such variations.
The same applies even if you don’t think of your property as an investment. Having a margin of safety is still important to ensure you can conserve cash flow and protect yourself in drastic situations – such as if you lose your job. It also applies when you are looking at upgrading from a HDB to an Executive Condominium or private property. Unexpected delays, both in your new condo and in selling your old one, can create a cash flow crunch if you fail to account for them using a margin of safety.
This is all makes sense from a theoretical perspective. But what about applying this concept practically?
Applying “Margin of Safety” to Property – 3 Questions to Ask Yourself
Since there is no universal margin of safety that is equally applicable to everyone, it is impossible for this article to give you an individualised prescription (for that, you should contact one of our Home Finance Advisors). Further, there are also different aspects of margin of safety to consider.
So, what we can do is give you a series of questions to ask yourself. These questions can help you better determine the appropriate margin of safety for you from multiple aspects.
Question #1 – What is the “Cash Value” of the Property I am Thinking of Buying?
Property is an illiquid asset. If you want to convert your property into cash, it’s going to take some time – months even, depending on the market conditions you find yourself in.
Knowing this, a good question to ask is – if I needed to sell my property immediately, how much would I have to sell it for? This is likely to be lower than what you think the property “should” be worth, but that’s the whole point of this exercise.
Of course, it is highly unlikely you will be able to purchase the property at that price. But by simply estimating that price (such as by looking at the resale market) and using it as a comparison baseline, you will have a better idea of the margin of safety you have available.
This applies for both buyers and investors, though we would argue that is a compulsory step for the latter. Remember, the lower the purchase price, the higher the rental yield – even if there is no change in the rental income.
Question #2 – How Much “Liquidity Reserves” Will I Have On Tap After the Purchase?
A related aspect to the first question is your total accessible cash reserves post-purchase. This includes cash in the bank and the funds in your CPF Ordinary Account (since we are talking about property) that you can access for servicing home loans or subsequent property purchases.
The “cash value” in the previous question also comes into play here. Since that is the price you would likely be able to get if you wanted a fast sale, it could also form a part of this total number. The idea then is to compare this figure with:
The home loan balance. This tells you how equipped you are to repay it in full if you had to; and
The price of an alternative property. If you were forced to sell and move to a smaller property, how equipped are you to purchase an alternative property that you could still comfortably live in?
The greater your total liquidity reserves are compared to the above two numbers, the bigger your margin of safety.
Question #3 – How Much Cash Flow Room Will I Have After Servicing the Instalments?
The first two questions had to do with the value of the property and your own cash reserves. The final one has to do with your own cash flows, and it should be mandatory to ask this regardless if you are a buyer or investor. The government already tries to do this for you via enforcing TDSR regulations, but you should take it one step further.
This can be easily done by estimating your own TDSR and comparing it to the 60% hard limit. Remember that TDSR only accounts for your debt payments and not your other expenses. The TDSR margin of safety that is right for you would depend on your spending patterns and preferences. For one person, they might need a 20% TDSR to give them peace of mind. For another, they might be okay with a TDSR of 50%.
An Essential Framework for Evaluating all Asset Purchases
Before 2009, when MAS banned interest-only property loans, understanding your margin of safety was even more important. But this doesn’t mean that it has become irrelevant. In fact, with experts still unsure about how the global pandemic will play out, uncertainty has never been higher. To navigate an uncertain future, it is essential you keep margin of safety top of mind.
This article strove to give you some key questions you can use to assess your own personal margin of safety. But if you’re looking for personalised advice (say, for a specific property you are looking at), then go ahead and fill out this form – one of our professional Home Finance Advisors will contact you within three hours. And for the best information on all-things home financing, check out the rest of our Home Financing Guides.
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