QFIP-131: Addressing Built-in Biases in Real Estate Investment Flashcards
List causes of behavior biases in real estate
Market inefficiency
Inability to take a short position
Price discovery is not transparent
Illiquidity
High transaction costs
Investor perception that the majority of real estate returns comes from capital
growth
In reality, income drives the majority of real estate returns
Inspires irrational emotions
Owners can set a greater value than the intrinsic/market value to an asset because
they own it
What is framing bias?
Framing bias occurs when the way in which questions or choices are structured can
influence our decisions
Describe how framing is present in commercial real estate
Real estate assets are largely categorized according to industry, geography, or
style labels (i.e. ’Core’)
However, these labels are subjective and do not take into account other influential
factors, such as lease structure and tenant strength
The average market return of a specific industry or geographical market is
impossible to access
Framing effects within real estate can limit intellectual independence
Career-risk averse managers may seek safe investments, rather than take a risk for
the opportunity to outperform their peers
Explain how a commercial real estate investor can workaround the framing bias
Focus on property-specific factors that have a greater influence on real estate
returns than region or sector trends
Tenant risks: Ability of the tenant to pay the rent
Lease risks: Risks associated with the structure of a lease
Diversifying a real estate portfolio on these additional property-specific factors can
offer better risk/return characteristics
What is the anchoring bias?
Anchoring is the tendency to evaluate one metric with reference to another, even
when the comparison is flawed
Describe how the anchoring bias is present in commercial real estate
Many key parties in a real estate transaction tend to arrive at skewed valuations of
properties because of anchoring
Professional appraisers, brokers, and prospective real estate buyers anchor to
past price information on similar properties
Explain how a commercial real estate investor can workaround the anchoring bias
Investor should anchor on yield (i.e. income return) instead of capital returns
Historical data from real estate returns have shown that capital gains returns are
highly volatile
In contrast, income returns are relatively consistent/stable
In terms of asset valuation, investors should place more emphasis on a property’s
yield than its absolute price
A property with a high yield (high future income stream at a low price) is good value
Do not anchor to past economic growth rates or performance
What is the loss aversion?
Loss aversion is investors’ reluctance to realize a loss because they feel more pain
from a loss than pleasure from receiving a gain
Describe how loss aversion is present in commercial real estate
Reluctance to sell a property to realize a capital loss results in holding properties
irrationally
However, if an asset’s fundamentals are no longer attractive, it should be sold
Explain how a commercial real estate investor can workaround loss aversion
Apply a consistent investment process with a disciplined buy and sell strategy
Don’t hold on to poor investments just to avoid realizing a capital loss
Regularly review investments from first principles (i.e. would you buy the asset
now?)
What is home bias?
Home bias is the tendency to invest too much in a domestic region we are comfortable
with
Describe how home bias is present in commercial real estate
Over-investing in domestic real estate exposes the portfolio to concentration risk
Geographic diversification in a real estate portfolio can provide better
risk-adjusted returns
Explain how a commercial real estate investor can workaround home bias
Ensure portfolios are diversified across geographies to provide better
risk-adjusted returns
Diversify income streams across regions
For example, investors should diversify income streams by staggering leases to
minimize the risk that multiple tenants will exercise break clauses at the same time
What is herding bias?
Herding bias is when individuals stop thinking independently and start to blindly follow
the consensus from the crowds
Describe how herding bias is present in commercial real estate
Lures many investors to chasing real estate market trends
Relying on momentum in a passive, rules-based investing strategy is less effective
in real estate markets due to heterogeneity, illiquidity, and high transaction costs
