Nick Armet writes about investments for a UK firm. He has interesting views on our emotional connection to real estate. Here are some:
The asset class of real estate demonstrates a pronounced influence of behavioral bias.
Real estate is a highly emotive asset in most cultures. This can help explain phases of ‘irrational exuberance’ in property markets where prices move away from fundamentals.
Real estate markets suffer from a greater degree of information asymmetry than stock markets. No two assets are the same, and there is no central exchange. Sellers tend to know more about assets than buyers. This is a fact, which real estate intermediaries can exploit. The quality of, and access to, information is much poorer than in stock markets.
Human subjectivity tends to play a much more influential role in the operation of this market than in other more information-efficient markets.
Studies provide similar support for the idea that sharp appreciations in property prices are at least in part due to over-optimistic expectations. In fact, models of economic fundamentals explain only between 10% and 40% of changes in property prices.
It is clear that real estate prices are very volatile, but this volatility is not fully explained by fundamentals. The behavior of investors and real estate market participants themselves is the issue.
Herding and Groupthink
Can explain why pricing moves away from fundamentals and demonstrate other implications. Herding can encourage over-investment in certain markets and sectors. For example, the London prime property market was a significant beneficiary of real estate sentiment in recent years as investors strongly favored prime assets in the post-financial crisis environment.
Despite the fact that real estate is an asset class which demands a long-term perspective, investors show a repeated bias towards fast and short -term return.
When herding combines with loss aversion, we can see some of the most disastrous consequences in real estate because of the illiquid nature of this asset. Real estate investors are highly sensitive to capital loss. We know that losses are felt as least twice deeply as gains.
Prices that are low can cause behavior that results in spending as much – or even more – as would have been spent buying a property or stock with a higher price tag.
One way to deal with the denomination effect in real estate is to get a realistic valuation – and how much the required fixing up will cost. You also need to consider the time involved in making the property livable. These factors are relevant whether looking at the property as an investment or a home. What looks cheap at first sight may not turn out to be.
Can have a negative impact on real estate investors, particularly those who bought property at elevated prices during a bubble. Loss aversion often makes real estate investors reluctant to sell when prices fall, even when it’s unlikely that prices will bounce back anytime soon.
By hanging onto a property that has lost money, investors may miss out on the opportunity to invest that money in something more profitable.
Status Quo Bias
Every investment, whether it’s stocks, bonds, real estate or commodities, fluctuates in value. Prices rise, and they fall, and then they do it all again… and again.
Despite this predictability, most investors are caught off guard by these market cycles. Real estate prices rise, oftentimes very quickly, and then the bubble bursts, leaving everyone surprised. It’s such a surprise because of status quo bias.
Investors buy real estate in hot markets because they expect it to continue going up. Investors expect this because the market has recently been rising. Status quo (Latin for “the state in which”) bias helps them forget about cycles.
¨This time is different, never is¨. Change is hard and going back to the status quo is easier than doing anything. Take time to think about the decision you need to make. Change will come more easily if you take the time to get used to it. But give yourself a deadline or you will go back to loss aversion.
This article is based upon Flex MLS reporting, legal opinions, current practices and my personal experiences in the Puerto Vallarta-Bahia de Banderas areas. I recommend that each potential buyer or seller of Mexican real estate conduct his own due diligence and review. If you have any other questions, contact me through my website.Harriet Murray