Source: HomeServicesAmerica

In this year’s annual Berkshire Hathaway ( NYSE: BRK-A ) ( NYSE: BRK-B ) Letter to Shareholders. Warren Buffett told the story of two successful real estate investments he made several years ago. As we know, when Warren Buffett gives advice. we should listen.

Warren kept his story general enough to illustrate his points about investing in a broad sense. Here, we will break down a simple real estate investment — buying a rental property — and look at how Buffett would do it.

Step 1: Real Estate is expensive. Line up your financing.

For most of us mere mortal investors, buying real estate will involve getting a loan. Fortunately, loans for rental home investments are very common and virtually any bank can help you.

Like getting a home loan, there are a few basic considerations, most of which should be obvious. You must have a good credit score. You must have enough cash for a down payment and enough leftover for a buffer in case there is a repair or extended vacancy. You must have a plan in place to get the home rented, keep it rented, and collect the payments.

At this point, its smart to go ahead and visit your bank of choice and discuss your options. Some banks will finance a rental home for 30 years, like a traditional mortgage. Others will require a shorter payback period, many times 20 years. I generally recommend negotiating for a longer term loan, knowing that you can (and should) pay it off more quickly.

Step 2: Find a good property manager

For some people, managing the property themselves makes sense. I am not one of those people. Neither is Warren Buffett. In this year’s letter, he is very clear about his intention to run his farm (emphasis added):

I knew nothing about operating a farm. But I have a son who loves farming, and I learned from him both how many bushels of corn and soybeans the farm would produce and what the operating expenses would be.

He didn’t have any intention of managing his apartment building investment either (emphasis added, again):

I joined a small group — including Larry and my friend Fred Rose — in purchasing the building. Fred was an experienced, high-grade real estate investor who, with his family, would manage the property . And manage it they did. As old leases expired, earnings tripled. Annual distributions now exceed 35% of our initial equity investment. Moreover, our original mortgage was refinanced in 1996 and again in 1999, moves that allowed several special distributions totaling more than 150% of what we had invested. I’ve yet to view the property.

I don’t want to spend my money and time advertising the property in the newspaper, on the Internet, and then having to show the house myself. I don’t want to check credit scores or verify a tenant’s income. I don’t want to wake up to a 4am phone call because the toilet is clogged. I don’t want to do all this work; I don’t have the expertise or energy to do it to its full potential.

Fundamentally, that’s why it’s worth the money to hire a pro.

Ask yourself, when was the last time a stranger asked you personally if you knew of a rental they could move into. Probably never. Random strangers walk into property management offices every single day asking that exact question. Want your house rented quickly? Hire a property manager.

Property managers are also your source for expert advice on valuation, rental rates, and other local micro economic factors that will have a direct impact on your investment. The value of a rental property is in large part derived from the cash flow it generates; in this way appraising the property is very different from a typical owner occupied house. Valuations vary from town to town and even neighborhood to neighborhood. A good property manager understands the area and can help you find the right investment for you.

Its worth more than the 5-10% you’ll pay for a property manager for the peace of mind, the simplicity, and the marketing they provide. Hire a pro. Buffett puts it succinctly, But if you aren’t [an expert], you must recognize your limitations and follow a course certain to work reasonably well.

Step 3: Do the math

For me, this is the part where real estate investing gets fun.

Buffett advises us to Focus on the future productivity of the asset you are considering. If you don’t feel comfortable making a rough estimate of the asset’s future earnings, just forget it and move on. For us, this means doing the math.

When a typical American goes house shopping, there isn’t really any return on investment calculation to put a ceiling on how much should be spent. With rental properties, there is.

Let’s say that a house is for sale for $100,000. The house has a good rental history and generates $12,000 in rental income per year. You will be putting in a 20% down payment and using a bank loan to fund the remaining 80% of the purchase.

With the skeleton of the deal laid out, we can start digging into the numbers. The $12,000 in rental income excludes the expenses associated with owning the home. We’ll assume a 10% fee right off the top for the property manager (which again, is absolutely worth the cost). And then there are the repairs, maintenance, and other general costs associated with operating the property. If the AC breaks, plumbing bursts, or roof sags, its on the homeowner to pony up for those repairs.

Looking at the rental history and tax returns for the property can help you estimate a budget for these repairs on an annual basis. Always verify these numbers with tax returns if possible. If that is not available, the home’s prior property manager should be able to provide a high quality, itemized statement of profit and loss. Don’t buy the house if the seller either can not or will not share this information. Non disclosure is more than a red flag, its a deal-breaker.

Let’s assume for this example that repairs work out to a consistent 5% of income annually. That means our real cash flow from the property, before paying the bank debt, is actually $10,200 per year.

Now, we must factor in bank debt and a contingency. Including a contingency is always a good idea when evaluating a real estate investment. The fact is things can and will go wrong. Just one month of unanticipated vacancy can erase nearly 10% of your cash flow.

For the bank debt portion, let’s assume that you are able to obtain a 20 year loan at 6% interest. The yearly payment on that debt is $6,877.74.

Bringing all the projected income and expenses together, we can project that annual cash flow will be $2,122.26. Based on your initial 20% down payment, you can expect an annual cash return on investment of 10.6%.

But wait, there’s more.

Investments in rental property can return more than just cash flow. Come tax time, the interest on the bank debt can be deducted as an expense, lowering your tax bill. And you can claim big deductions for depreciation expense (your accountant will handle this).

Bottom line is a profitable rental home can be very effective at lowering your tax bill. The exact calculation depends on a host of factors outside the scope of this article, but a call to your accountant should give you a general idea of what these savings could be for your specific situation.

Just like an investment in the stock market, the value of your rental house could appreciate over time. Depending on the location, you could reasonably expect 2-5% appreciation per year. However, real estate values are just like any other asset-values can go down just as well as they can go up. But over the long term, the intrinsic value of real estate should protect you from a dramatic loss of value. Don’t think in terms of one or two years, think in terms of five, ten, or twenty years.

Annual principal pay downs on a 20 year, 6% loan

Including the gains from the loan paydown will approximately double your annual return on investment from 10.6% to 21.3% just in year one, and that doesn’t include the potential tax savings! So while your property is cash flowing and appreciating, you’re also building equity by steadily paying down your bank debt. In the first four years, you will build over $9,000 in additional equity just from making your bank payments on time.

The calculation isn’t done yet. Now we must think about the risks

On the surface, this investment seems like a slam dunk. You are projecting a strong return on investment. If you’ve done your math, you’ll only buy with the finances make sense. You can sit back in your chair and live the investing good life, not unlike what Warren Buffett is probably doing right now in Omaha, right?

Well, maybe. Nothing is ever quite so simple. Buffett says that Games are won by players who focus on the playing field — not by those whose eyes are glued to the scoreboard. That means playing good defense and mitigating risks.

This deal requires a big bank loan to achieve these returns, and with leverage comes risk. If something ever goes wrong and eats the property’s cash flow, you are still on the hook to pay the bank. A few months of vacancy or a major repair can very, very quickly negate any returns. The bank doesn’t care. They want their cash every month, on time, in full.

Some of you may also be looking at the numbers and thinking to yourself, You know, I don’t mind doing the repairs. I do them at my own home anyways; I can handle them at one more house and save 10% per year! While I commend your commitment to cost control, this decision can lead to a serious financial blow.

What if your ads on Craigslist go unanswered? What if you over or undercharge on the rent? Over charging leads to a vacant house. Undercharging leaves cash on the table. The property manager will likely have agreements in place with local repairmen to reduce repair and maintenance expenses. Saving 15-20% on a major repair could be the difference between the black and the red.

In this case, its worth it to hire a pro.

Once you’ve reached this point, you’re prepared to make a financial decision. Is the projected return on your investment enough to justify the risks?

My rule of thumb is if the property can cash flow such to pay off the entire mortgage in 10 to 15 years, then yes. Otherwise, its too expensive and not worth the returns.

Buffett gave you the theory, now we’ve given you the details

With this easy, three step process, you are now prepared to begin your journey toward a real estate investment. The process can be challenging, so rely on people you trust to help you — real estate agents, appraisers, bankers, and property managers all have experience and expertise that can help you avoid pitfalls and dramatically improve your chances for success.