Real estate is a highly emotive asset in most cultures. ‘Irrational exuberance’ in property markets can cause prices to move away from fundamentals. Buyers move away from markets when negative press reports are released. The truth or vetting of what happened, is not necessary. Unfortunately, emotional reactions trump logic.
Real estate markets suffer from a greater degree of misinformation than stock markets. In real estate, no two assets are the same.
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 support for the idea that sharp appreciations in property prices are at least in part due to over-optimistic expectations. Models of economic fundamentals explain only a range between 10% and 40% changes in property prices. Extremes for either double appreciation or great losses, are not trackable or verifiable.
It is clear that real estate prices are very volatile, but this volatility is not fully explained by the lack of fundamentals. The behavior of investors and real estate market participants themselves is the issue when emotion is greater than logic.
Herding and Groupthink
Pricing moves away from fundamentals and demonstrates other implications. Herding can encourage over-investment in certain markets and sectors. London prime property was a significant beneficiary of real estate optimism in recent years as investors strongly favored prime assets in the 2009 post-financial crisis environment. When Brexit won the referendum in 2016, uncertainty and lack of confidence in the future pressed down prices.
Even though real estate is an asset class demanding 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. Losses are felt at least twice times more than 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. Why? No realistic checking ….
A way to deal with the denomination effect in real estate is to get a realistic valuation. How much is the required repair and upgrading going to cost. You also need to consider the time involved in making the property livable. These factors are relevant whether looking at property as an investment or a home. What looks cheap at first sight may not turn out to be. You got the home for “a steal.” You did not check what it would cost to make needed repairs and upgrades, so you spent more than the nicer house next door.
Loss aversion can make it worse if you don’t make a decision.
Can have a negative impact on real estate investors, particularly those who bought property at elevated prices during a bubble.
Loss aversion (fear of loss) 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 or Denial
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. Very seldom is the pendulum in the middle . . . most of the time we are out of balance.
Despite predictability, most investors are caught off guard by these market cycles. Real estate prices rise, often very quickly, and then the bubble bursts, leaving everyone surprised.
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 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.
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 into denial.
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