The Psychology of REI: Understanding the Underlying Drivers of Real Estate Investors
Each day, we read some financial articles to stay up to date on what the mainstream narrative is on current events. Paying attention to the headlines makes it impossible to miss the conversations surrounding the stock market volatility, political tensions rising between nations, and a looming banking crisis.
Whether it’s regarding a natural disaster, Amazon announces more layoffs, or a political scandal, the news has an impact on our investments and investor’s decision-making skills. An investor’s emotional state, fear psychology, and comfort with risk contributes to the stability and volatility of many investment markets.
Psychology and Real Estate Investing
Even though real estate is an illiquid asset, and thus, doesn’t bend to the whims of investor mania like the stock market, there’s a strong argument that the real estate market and choices made by individual investors are influenced by psychology and emotions.
That’s why we’re going to dive into some of the psychological factors that can impact an investor’s decisions, and how they play into the risk and trends of the real estate investing space.
According to Investopedia, “the observation that human beings experience losses asymmetrically more severely than equivalent gains” is called loss aversion. In behavioral finance, this term is used to explain why people would rather avoid a loss than achieve a gain. This proves that losing money is more painful than the joy of making money. It doesn’t take a Harvard psychologist to understand the significance of this when it’s applied to real estate investing. If an investor is extremely afraid of losing money, this can cloud their judgment, and lead them to missing out on a great opportunity when one comes across the table.
Monte Carlo Fallacy
The Monte Carlo Fallacy, aka gambler’s fallacy, is something you’ve probably heard of, or even experienced yourself more than once. The Monte Carlo Fallacy, as defined by Investopedia, describes the belief “that a certain random event is less likely or more likely to happen based on the outcome of a previous event or series of events.”
Here’s an example.
Let’s say you’re playing a “coin flipping” game. Considering the coin has landed on tails 10 times in a row, a person may assume the coin is more likely to land on heads.
But this is just not true. Regardless of the number of times the coin has been flipped, and has landed on heads or tails already, there is still a 50/50 chance that the coin will land on heads. The coin doesn’t know or remember it has already landed on heads.
This connects to the assumptions real estate investors can make relating to their portfolio. If a real estate investor has done deals in the past where similar deal usually generated strong returns, but they haven’t seen those strong returns on the last few deals they’ve done, they may be guilty of the Monte Carlo Fallacy. They might falsely believe that they are now “due” for better performance from a property to “rebalance” the scales. A real estate investor should fall back on their investment principles, and look at deals through the objective lenses of thorough underwriting and extensive due diligence.
As discussed in an article in The Street, both male and female clients are vulnerable to how attractive a female real estate agent is. The more attractive a female agent is considered to be, the higher price the buyer is willing to pay. This means that people are willing to spend more money on real estate based on appearances. In this case, it’s a person. But I’d argue this also applies to the appearance of the property, or some other superficial aspect of the property.
As multifamily investors, we spend a lot of time and effort underwriting deals, touring properties, meeting with brokers, and staring at the ceiling wondering if we’ll ever find another deal that pencils out.
So, when you find a deal that makes sense at first, or find one in a market you’ve been wanting to break into forever, but discover something that kills the deal and makes you utter those dreaded words (“It’s pencils down on this one.”) it can be the ultimate let down.
Some investors might be tempted to manipulate the numbers, or overlook things they perceive as “hair” on a deal, but this can be a major risk and lead to poor investment decisions.
This is why it’s important to beware of potential bias and mitigate it by falling back on strict investment criteria. It also doesn’t hurt to have partners who you can share underwriting with. Two or more heads are better than one, and it decreases the risk of one person experiencing a severe lapse in judgment due to bias or eagerness to make a deal work.
I’ll Do It! Wait, No I Won’t! Or Maybe I Will?
Analysis paralysis is defined by Investopedia as “an inability to make a decision due to overthinking a problem.” As a real estate investor, the amount of data you have access to when looking at a deal can be overwhelming. This can result in an endless debate over the pros and cons of doing a deal, and leave an investor unable to make a decision. Fear of choosing the wrong path leads to analysis paralysis.
Analysis paralysis keeps most people who are interested in real estate investing on the sidelines. If a passive investor has a great investment opportunity presented to them, but isn’t able to pull the trigger on investing because of fear and uncertainty, they’re going to let chances at growing their wealth pass them by. All investing involves some level of risk and uncertainty. It’s important to accept this. Remember, investors invest. So, make sure to conduct research. Analyze the benefits and risks associated with any investment opportunity. But know when it’s time to look past fear and take action.
Remember Theodore Roosevelet’s famous quote:
“It is not the critic who counts; not the man who points out how the strong man stumbles, or where the doer of deeds could have done them better. The credit belongs to the man who is actually in the arena, whose face is marred by dust and sweat and blood; who strives valiantly; who errs, who comes short again and again, because there is no effort without error and shortcoming; but who does actually strive to do the deeds; who knows great enthusiasms, the great devotions; who spends himself in a worthy cause; who at the best knows in the end the triumph of high achievement, and who at the worst, if he fails, at least fails while daring greatly, so that his place shall never be with those cold and timid souls who neither know victory nor defeat.”
Real estate investors need to be aware of the way their thoughts and biases impact their approach to real estate investing. Reflect on your own mindset and address the attitudes or beliefs that might be holding you back from reaching your real estate goals.