QFIP 131 - Addressing Built-in Biases in Real Estate Investments 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
Why does efficient market hypothesis not work well in real estate?
- The efficients market hypothesis suggests that there is an equilibrium price for real estate
- However, in reality, real estate markets tend to be biased one direction or another
- Bullish sentiment can create positive feedback loops that push up real estate values beyond their fair value
- These positive feedback loops can sustain bubbles in property values that can deflate quickly once natural limits are reached
What do proprety owners and prospective sellers anchor to in real estate investing?
They anchor to prices they paid for the property
Descirbe additional way how loss aversion is present in typical real estate market
- In typical real estate market cycles, investors may hold on to their properties over the first two phases of market prices falling because of loss aversion
- They will then finally give in and sell during the third wave of selling pressure
- Ironically, though, this is normally the best time to buy, since prices are lowest and income yields are highest
Additional workaround to deal with herding bias in real estate investing
Recognize that markets tend to over-and under-react, so default to being a contrarian
What is 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?
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?
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?
To invest too much in a domestic region we are comfortable with
