Editor’s Note: Dennis Fassett is a former corporate finance executive turned real estate investing “Cash Flow Mercenary.” Dennis specializes in single-family and multi-family cash flow properties and thoroughly enjoys assisting his fellow investors with their own strategies, including how to buy your first apartment building.
As an ongoing contributor to Mogul’s “Market News Updates,” Mr. Fassett provides us with his own unique, lively, and thought-provoking commentary on the timely industry news and events of today that are impacting our industry. And be sure to check out his other super-helpful Market News Updates. For now, enjoy...
From Dennis Fassett, Cash Flow Mercenary...
I read a pretty cool article the other day that talked about a behavioral psych study about what goes through people’s minds when considering a real estate investment.
I have to admit, though, that I was highly skeptical when I first saw the headline. I mean, I’m not one who goes for the psychobabble BS that you see on Successories posters and Facebook memes.
I’m more of a brass knuckle type A, with a brass knuckle type A wife and 4 brass knuckle type A kids.
With a family motto that doesn’t surprise anyone:
Second place is just the first loser.
But the title piqued my interest anyway, so I read on…
The interesting thing the author of the study noted was that the decisions commercial real estate investors make, which they think are rational, often lead to herd-like behavior and emotional reactions that cause bubbles and crashes.
He went on to write that,
“Behavioral 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.”
He said that if real estate investors were rational, then the booms and busts that the cycle experiences would be much less pronounced.
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.
To support his analysis, the author pointed out 5 key areas of behavioral psych that feed into this pattern. From his study, they are:
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 crystalize 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 3.'
When markets start to fall, at first investors think they can ride it out… and that 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 behavior 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.
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:
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appraisers use past price information to decide current value
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brokers anchor their valuation of an asset to their asking price
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buyers anchor the price they will pay to what they have bought previously
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sellers anchor their price to what they bought it for (as explained above)
The author 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 2 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.
The Herding Bias
What is it?
The wisdom of crowds can be powerful, but in investing, 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 and 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?
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.
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 favorable.
How to avoid it?
Diversify across countries to avoid concentration in a single market, but look for markets and assets that have favorable income or lease structures.
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.
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.
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.
Sound familiar?
They do to me and I’m guilty of some of them.
So the bottom line is pretty simple – don’t let your brain get in the way of making good real estate investments.
I’m Listening…
Agree or disagree with my assessments? Share below.