Why Your Brain Makes You Get Real Estate Investing Wrong
Many assume the real estate investment decisions they make are rational, but what if they are not?
A new research paper called "Addressing built-in biases in real estate investment," produced by Fidelity International, takes the tenets of behavioural psychology and economics and applies them to institutional commercial real estate investment.
Author Matthew Richardson shows how the decisions commercial real estate investors make, which they think are rational, often lead to herd-like behaviour and emotional reactions that cause the bubbles and crashes the sector experiences on a fairly regular basis.
The paper is topical — Richard Thaler, the economist who did much to advance the field of behavioural economics, was awarded the Nobel Memorial Prize for economics last week.
Here is a brief intro to how the field applies to commercial real estate, the five key findings and how investors can avoid making the irrational but understandable mistakes that cause real estate prices to oscillate wildly.
Behavioural Psychology And Economics And Their Application In Commercial Real Estate
Behavioural psychology upends the idea the people are rational and always act in their own best interest, and instead reveals how the brain's ingrained biases and ways of approaching problems make us act irrationally.
These ideas have been applied to economics and finance, particularly stock market investing, but Fidelity applies them in detail to institutional commercial real estate investment. The sector is particularly prone to the kind of issues behavioural psychology highlights for various reasons, including the fact that it is opaque, illiquid and people tend to get emotionally attached to buildings.
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 five key areas of behavioural psychology that Fidelity argues feed into this pattern.
1. Loss Aversion
What is it? Psychological experiments have shown that people feel the pain of a loss about twice as acutely 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.
Applications in real estate? Real estate investors are incredibly reluctant to crystallise a lose, 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 (we will get to herd behaviour in a moment) 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.
2. The Anchoring Bias
What is it? Comparing one figure to another that you already have in your mind even though they may not actually be linked.
Applications in real estate? 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.
Fidelity argued that the most pernicious 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.
What to do about it? 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.
3. The Herding Bias
What is it? The wisdom of crowds can be powerful, but in investment sticking with the crowd can be a bad idea. ‘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.
Applications in real estate? A major cause of booms and busts. 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, 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.
How to avoid this? Resist 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.
4. Home Bias
What is it? We inherently prefer things that are familiar to things that are foreign or new.
How does it apply to real estate? Investors have huge exposures to their domestic 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 favourable.
How to avoid it? Diversify across countries to avoid concentration in a single market, but look for markets and assets that have favourable income or lease structures.
5. The Framing Bias
What is it? If a question is difficult or complex, our brain substitutes it for a more simple question, even if it is not quite the same. For example, when real estate investors are faced with the question: ‘What is the true nature of this real estate investment?’ They substitute it for: ‘Which familiar asset class does this investment resemble, and what are the characteristics of that asset class?’
Applications in real estate? 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, City of London offices, currently the darling of Asian investors, looking for safe returns, are one of the most volatile sectors out there.
Similarly, investors might have a strategy of buying 'Washington offices' or 'German 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, Fidelity points out that the difference in returns between the best- and worst-performing Frankfurt 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.