Warren Buffett and Charlie Munger, the Chairman and Vice-Chairman, respectively, of Berkshire Hathaway, Inc. (BHI), are the two best long-term stock investors in history. Their track record at BHI is unprecedented with an average annual return from 1965 through 2019 of 20%. If your grandparents were lucky enough to invest $1,000 in BHI in 1965 and held it to today, it would be worth $18.9 million.

One of the most popular investment proverbs from Buffett/Munger is to "know what you don't know." This means that as an investor in real estate or stocks, it's almost impossible to know everything about every property type or corporate industry sector. To be a successful investor, you need to understand your "circle of competence" and stay within that circle to lower risk and increase return. A circle of competence can be widened over time, but only slowly and major mistakes are often made when straying from this discipline. Charlie Munger's great quote is also quite prescient, "knowing what you don't know, is more useful than being brilliant."

Most experienced and successful CRE investors are proficient in the four major property types of; office, retail, apartments and industrial, but many do not fully understand some specialized sectors like data centers, senior housing and manufactured housing. The data center market is characterized by hyperscale and colocation facilities, rents based on kilowatt-hours of power and very technical operating issues. The senior housing market is more of an operating business than real estate investment and involves independent living, assisted living and skilled nursing facilities.

Manufactured housing is owning land that is leased on a monthly basis to trailer and recreational vehicle owners for rental income. If these three sectors are not within your circle of competence, that's fine, don't invest in these areas. If you are a long-time apartment owner/manager, then keep your circle of competence to the apartment sector. Even the apartment sector has many subsectors that could be invested in, like low-income housing, student housing, low-income tax credits and military housing.

Knowing what you don't know, and the circle of competence are critical psychological instincts in stock investments because of the large number of different industries, corporate structures and operating regimes. Institutional investors can make bad investments and get into trouble when they veer out of their circle of competence. How many investment managers really understand the intricacies of the biotech and oil and gas industries, but have millions invested in these businesses? If your circle of competence is very low in these industries, then you are better off buying a diversified industry exchange-traded fund, which reduces the nonsystematic risk.

Not knowing what you don't know is what happened to the founders, equity investors and lenders in the disastrous business model and IPO of WeWork. They started and funded a real estate company that attracted billions in debt and equity investments, but no one had any significant CRE knowledge or experience. They thought they had discovered a new business model, office suites, or leasing a full floor in an office tower and releasing the space to start-ups and millennials in small offices and workstations, to make the rent spread. Office suites have been around for 50 years and can be found in every sizable office market in the country. They invested in an industry outside their circle of competence, lost billions and did not know what they didn't know.

Joseph J. Ori is executive managing director of Paramount Capital Corp., a commercial real estate advisory firm

Instant Insights /

CRE Investors Need to Stay in Their "Circle of Competence"

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