How buyer bias affects the real estate market—Part I

Jun 24th, 2015 | By FCT

In the upcoming July newsletter, we’ll been casting a hard eye at the dearth of hard data around the (very) human process of buying a house. In this blog and its successor, we’ll sort through some serious professional literature to see how to land the plane: precisely which biases should real estate professionals be conscious of when examining their own strategies, their client needs/wants, and the marketplace generally?

Short answer: whichever apply. So here’s a roadmap through the thickets of bias that sprout whenever the human mind applies itself to a real estate deal—because none of us ever, ever wants to lose money.

For starters, a killer quote:

“If every real estate problem is treated as a financial problem, scientists miss the opportunity to use insights from other disciplines. Real estate does not only concern finance, but also marketing, management, law, planning…the similarity of all these disciplines is that they derive their existence from human behaviour. Thus, research should go beyond cash-flows and provide space for the psychological side of stakeholders in real estate.”

(Black, R.T., Brown, M.G., Diaz, J., Gibler, K.M., & Grissom, T.V. (2003). Behavioral research in real estate: A search for the boundaries. Journal of Real Estate Practice and Education, 6(1), 85-112.)

The point is, if we know the biases, we can far more cogently understand why a particular market isn’t behaving the way orthodox financial fundamentals ordain they should.

First off, are we dealing with the raw market price of a house or the value of a home; the first is a purchase/investment decision—the second is…complicated.

But the bottom line is the bottom line: everybody wants to know what a house in play is really worth.  It’s a given that risk and returns aren’t completely understood. Because of market complexity (the sheer number of players involved, from agents to marketers to buyers to owners to lawyers to, well, FCT!) and the underlying belief that real estate investment is a riskless long-term investment, clearly, given the firestorm of 2008, that’s untrue: millions lost their homes.

Most researchers rank over-optimism as the leading bias for homebuyers; the last big survey showed would-be buyers expected 11% ROI annually and little risk. Over-optimism also colours perceptions of future interest rate levels—and under-reacts, studies show, to the outright risk of interest rate movements.

This is nowhere more true than in the vast gimmicky literature churned out for real estate investors and the media at large. (Interestingly, downside-averse real estate owners tend to own more volatile equity stakes, which is about as counterintuitive as it gets.)

Over-confidence differs from over-optimism: this bias is all about the illusion of control—”I can beat the risk factors”—and is often found in armed forces personnel heading into combat, who believe it won’t be them caught in the crossfire. Same deal (far less dangerous) applies to the wishful thinking of otherwise rational minds in the midst of a real estate transaction.

Worse, the higher the confidence, the greater the quantum of risk. Why? Because, psychologically speaking, human beings reason falsely first (get the inference wrong) and then evaluate the probability of risk when (more or less) they’ve forgotten the underlying reasoning….which was quite possibly wrong in the first place.

This would be hilarious as a pattern if the behaviour weren’t so widespread and influenced, in turn, by hindsight bias, a fancy term for clairvoyance: you think you “know” certain events before they happen, which instills the belief that unpredictable events (a gas or water main failing the day your deal closes, flooding the street and every basement there) are predictable.

Confirmation bias supports beliefs, not reality: “Catching a real estate boom is a wise investment,” so the theory runs; confirmation bias covers off lost investment by chalking the loss up to bad luck—not buying in a boom, with its attendant risk of market correction. (We’re wired to love “the sure thing,” is the takeaway.)

Getting the picture? These biases aren’t necessarily toxic taken one at a time (although over-optimism is rife in most real estate markets) but in aggregate, influenced by media and accelerated by rumour and gossip, biases corrode value and an objective view of what’s really going on. In this sense, nothing succeeds like failure; you learn that there are no guarantees but that risks are knowable. Most savvy investors know this, in their bones: fail fast and with the least possible risk.

We’ll examine the psychology of risk in part II of this blog, then continue on with REAL ESTATE 101B in July, when we take a look at “your brain on real estate.”

Categories: EXPERT/ease, Real Estate

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