In this age of instant information and a disdain for delayed gratification, most people believe the Real Estate Investor makes rational decisions; but what if most of the decisions we make as Real Estate Entrepreneurs are influenced by behavioral history ingrained into our minds by past learning experiences?
A new research paper called “Addressing built-in biases in real estate investment,” produced by Fidelity International, takes the principles of behavioral psychology and economics and applies them to commercial real estate investment. The paper explores how the decisions commercial real estate investors make, which they think are rational, often lead to herd-like behavior and emotional reactions that cause the bubbles and crashes the sector experiences on a fairly regular basis. As I read this paper, I had the feeling the Study made jumps in assumptions; but I will let you decide.
Behavioral Psychology and Economics would appear on the surface to be opposite in both application and theory; but what if there is a commonality between how the brain applies the ingrained biases and flips the idea that Real Estate Investors are rational and always act in our own best interest. Instead we have ingrained biases and ways of approaching problems which make our problem solving process questionable? These ideas have been applied to economics and finance before; now they are applied to Commercial Real Estate Investors. You may think this Is not applicable to you; but, whether your investing in a distressed single-family home or an office building in New York City, the same kinds of behavioral issues and psychological ingraining of biases and ways of approaching problems make us act irrationally.
Real Estate Investors are particularly prone to the kind of issues behavioral psychology highlights for various reasons, including the fact that it is opaque, not liquid and people tend to get emotionally attached to the buildings they acquire. A few years ago, I was involved with a consortium of Investors who began negotiations with the Empire State Building Realty Trust. As a point of clarification: The Empire State Building is an iconic property and the Investors proposal included the Non-Profit owning the The Empire State Building in perpetuity so it couldn’t be acquired by a foreign buyer, which was the only reason I was involved with the 501(c)(3) which I operated. The Trust owns 15 major Office/Retail properties in Manhattan and Fairfield County, CT.
As with most of the premium properties in these kind of markets, this I was an attempt to begin negotiations. The talks never progressed beyond the Attorney to Attorney and the properties remain in control of the Trust. In my mind, if someone is waving $8+Billion in your face, I would at least listen to what they had to say; but if real estate investors were rational, then the booms and busts that the cycle experiences would be much less pronounced. As prices get higher demand should drop off. Instead real estate is particularly prone to positive feedback loops. As prices get higher investors pile in looking for quick returns. On the flip side, investors hold on to assets for longer than they should as prices fall, then finally capitulate when prices are at their lowest. There are key areas of behavioral psychology that feed into this pattern, which are covered in the next 5 paragraphs.
Loss aversion is what makes gamblers chase losses. What is it? Psychological experiments have shown that people feel the pain of a loss about twice as intensely as the pleasure of a gain. As a result, people act irrationally when trying to avoid losses. The old phrase about throwing good money after bad applies in Real Estate. Real estate investors are incredibly reluctant to accept a loss, and act irrationally to try and avoid this in a way that actually exacerbates real estate crashes. They are unwilling to sell an asset if it dips below the price paid for it or its last valuation. They hold on too long, and research shows that downturns follow a ‘rule of three.' When markets start to fall, at first investors think they can ride it out; then they know they are in trouble, but the pain of selling is too great; then people capitulate, everyone sells at the same time and the extent of the crash is increased. What can you do to avoid screwing yourself over? Do not hold on to an asset just to avoid taking a loss, try and view every investment as if you did not own it and be disciplined.
There is a phrase in Psychology called the anchoring bias where there is a common human tendency to rely too heavily on the first piece of information offered (the “anchor”) when making decisions. During decision making, anchoring occurs when individuals use an initial piece of information to make subsequent judgments. Once an anchor is set, other judgments are made by adjusting away from that anchor, and there is a bias toward interpreting other information around the anchor. For example: the initial price offered for a used car sets the standard for the rest of the negotiations, so that prices lower than the initial price seem more reasonable even if they are still higher than what the car is really worth. Everyone in real estate anchors: appraisers use past price information to decide current value; brokers anchor their valuation of an asset to their asking price; buyers anchor the price they will pay to what they have bought previously; and as explained above, sellers anchor their price to what they bought it for. The most malicious form of anchoring is the focus on capital value and capital gains, rather than income return, even though 80% of real estate returns come from income, investors base decisions on the chance of capital appreciation, something that the owner cannot actually control. If you do have to use a metric to compare two properties, use yields rather than capital value, as at least this has some reference to income. Focus on income return when making your investment decision and ignore past economic or real estate performance as it might not happen again.
Social proof is the technical term for doing the same thing as other people, often because you think they are in the know to avoid looking stupid. We see evidence every day on social media and it has become a negative in our society. In Real Estate it is called the Herd Effect. Investing is an area where herding is almost inevitable, because the situation is complex, there is lots of information out there and the right thing to do is not clear. So, when prices are rising quickly it seems wise to jump on the bandwagon and invest, for fear of missing out and maybe fueling the bubble. And when prices drop people also follow the herd — why are other people selling, what do they know that I do not? Forced selling by some kinds of institutions, like open-ended funds, can encourage others to sell, even though they do not have the same kind of pressure on them. You can avoid this by resisting the urge to act impulsively. Take a long-term view and if in doubt, be a contrarian, and buy when everyone is selling and vice versa.
Home Bias is the inherent preference to prefer things that are familiar to things that are foreign or new. Investors have huge exposures to their local market and limit the possibility of finding attractive assets in different markets. It is not just about investing in different countries for the sake of it but finding other markets where elements like income profile or lease structure, or rent-free periods might be more favorable. Diversification across self-imposed boundaries to avoid concentration in a single market makes sense; but look for markets and assets that have favorable income or lease structures.
The framing effect is where people decide on options based on if the options are presented with positive or negative like as a loss or as a gain. People tend to avoid risk when a positive frame is presented but seek risks when a negative frame is presented. The most famous example of framing bias is Mark Twain's story of Tom Sawyer whitewashing the fence. By framing the chore in positive terms, he got his friends to pay him for the “privilege” of doing his work. Real estate has come up with definitions for property risk like core, core-plus, value-add and opportunistic. But these are completely arbitrary, since every property is different. Investors might have a strategy of buying core property because they think it is safer, when in fact it can be more volatile than secondary assets. For instance, investors might have a strategy of buying ‘Washington offices' or ‘Chicago retail' to try and access the average return of these sectors. But again, since every property is different, it is impossible to access this average return, and it can be risky. For example, the difference in returns between the best- and worst-performing Miami offices was 33 percentage points, in spite of the fact that the sector as a whole had a 2.4% return. How to avoid this? Ignore pretty much everything apart from the income offered from the tenants in your building, and the structure of the leases. If you want diversification, have a diverse range of tenants and leases expiring over a staggered period. Ignore classifications like core or core-plus, and trying to buy a sector, like New York offices.
Most people would like to think that they are relatively objective about their decision making. This is perhaps especially true when those decisions have to do with real estate investing. We can easily say things like, “it's all about the numbers,” but our human psychology does not drop away in favor of a computer-like logic when we have to decide whether to buy this condo rental or that mobile home. As you have read, we are affected by all sorts of prejudices and subtle psychological forces. Use the understanding of your personal thought process as you analyze your recent project. What did you learn? How will you correct the mistakes? Calculate the bias of each acquisition before you jump. It will save you money.