In 2017 Richard Thaler, an economist and professor at the University of Chicago, won the Nobel Prize for his work in behavioral economics. Thaler had built on the prior works of Daniel Kahneman and Amos Tversky, who themselves had won a Nobel Prize in 2002. Behavioral economics is the psychological study of decision-making. Thaler, Kahneman and Tyversky determined that humans are not rational and that our brains are wired to make instinctual decisions, even when they have great consequence. One application of this theory is very apparent when investors make emotional decisions in hopes of maximizing investment returns.
Luckily, there are three strategies you can employ to overcome your unknowing biases and become a much better private real estate investor:
1. Don’t Fall for Projections. Clients regularly bring deals to my team that promise very attractive returns. However, after we run our own financial analysis, the high projected returns highlighted in the marketing efforts are often a fraction of what was originally presented. Investors have a tendency to believe that a high projection provides protection against loss – a big mistake. For example, if a deal is projected to achieve a 30% internal rate of return, then it shouldn’t be assumed that it would still make 20% if it misses. The expected value could be zero. Do not allow a deal to frame the expected return in your mind before it is properly vetted.
2. Passively Invest in Diversified Funds. Portfolio theory tells us that we should invest in many deals with different asset-level risk characteristics. We know this when investing in the stock market, as you would not put your entire 401(k) in a single stock. However, I’ve met many investors who have ended up in a couple of private real estate deals instead of investing in a diversified fund.
Investors make this mistake because of familiarity bias. We are drawn to what we know and see every day, and think this knowledge will mitigate risk. We all encounter real estate, whether it be at work, shopping or where we live. Real estate’s tangible nature gives us comfort and results in the dangerous assumption that because we interact with real estate we can effectively pick individual deals to invest in.
The reality is that real estate investing requires significant expertise in finance and local knowledge of the asset and asset type. It is necessary to understand discount cash flow analysis, growth rates, supply, capitalization rates, and market knowledge to have an educated opinion on any real estate business plan. Looking for a real estate fund over individual deals is a far better option to achieve diversification and usually results in higher returns.
3. Create a Process to Evaluate Opportunities. The best real estate investors run a process to select the best investments, focusing on the character and resources of the manager. David Swensen, Yale’s Chief Investment Officer, is a good example of this. Swensen has achieved 12% annualized returns over the past 20 years, allocating heavily to private real estate after establishing a data-driven process for manager selection.
Our minds default to making emotional, snap decisions based on feelings, without all the necessary information, and the only way to defeat this is by having a process to thoroughly vet the opportunity’s management team. Make sure you select fund managers who have historical market-beating returns, superior investment, asset management, and risk management teams, as well as clear competitive advantages. As a bare minimum, here are three things to look for:
Experience: If the manager has little experience, you should pass on the opportunity. Why let them learn on your dime? A track record of consistent success is critical.
Team: Do not invest in deals that require the manager to build operations; for example, if the business plan calls for the manager to hire internal property managers and leasing teams. You are again paying the manager to expand their business. It is unlikely that a newly formed property management and leasing team will outperform the market leaders.
Alignment: How much of their personal money do they have in the deal or fund? Investors need to be aligned with their manager, and co-investment is the easiest way to achieve this alignment. A successful manager should have money to invest in their deal to show that they believe in the opportunity.
If you feel that you aren’t equipped with the skillset to vet opportunities, you can hire an objective independent consultant to help. Or, you can move to a passive investing strategy and identify one manager that has passed your data-driven analysis so then you won’t have to redo your analysis on every single deal.