This article was originally published on the Forbes website.
Successful investing in private real estate takes more than deep pockets. Market expertise to underwrite properties and management experience to execute profitable business plans are critical too. Yet human traits can lead even the best private investors astray. Behavioral economics, the study of financial decision-making psychology, bares the subconscious biases that trigger real estate investment mistakes.
I studied behavioral economics as a graduate student at the University of Chicago under Nobel prize-winning economist Richard Thaler, whose central insight is that even a small intervention can lead to better outcomes. When applied to private equity real estate investing, Thaler’s research suggests investors should have a strict, methodical assessment process in place — an evidence-based framework to evaluate investments and control for hidden biases. That is how we work as private equity real estate managers at Origin Investments.
Seven steps, inspired by my knowledge of behavioral economics, can help a private investor avoid common real estate investment mistakes:
- Manage your portfolio before it manages you.
Studies show humans are wired to be lazy. So don’t underestimate the desire to skip the due diligence process. Follow a plan to avoid bad property purchasing decisions and a schedule for reviewing your holdings. Hold assets for the long term, but don’t neglect them due to inertia. Also, don’t let adverse events prompt you to act rashly. When markets turn volatile, you should be comfortable enough with your decisions to not to follow the crowd and sell.
- Choose a broad mix of real estate investments.
People are comfortable with things they know, a behavior that is known as familiarity bias. Choosing investments is similar to gambling in that it is decision making in the face of risk, and experiments show that people make gambling decisions based on the familiar — even when they have lower odds of winning.Don’t let familiarity limit your private equity real estate choices, or increase your risk of pouring too many resources into too few deals. Instead, consider taking on partners to invest smaller amounts in more deals. Or include different types of properties in the mix, based in different geographic locations. Real estate funds can also deliver a diverse portfolio of assets with different risk profiles, while minimizing the overall risk posed by an asset or two that doesn’t perform.
- Handle projections with care.
When deals are pitched to my team, the forecast for investment returns is always very attractive. When we do our independent vetting, the high projections fall apart. Yet the initial projection can create an anchoring bias, which is a behavioral economics term that describes the human tendency to rely too heavily on that “anchor,” or initial piece of information, when making decisions. For example, a deal that has a 30% internal rate of return could fall short — and even lose money. Don’t let a sales pitch frame how you think about a deal.
- Take risks together.
The expression “skin in the game” is a simple but effective investing rule about risk. If someone asks you to invest in their deal but doesn’t have their own skin in the game, you’re taking the risk — not them. New York University professor Nassim Taleb argues that having a stake in the outcome limits the downside of even speculative bets.This aligns with my philosophy of co-investment. Investors should look for deals where the sponsor holds significant equity. This proves the sponsor will work hard to ensure the deal is a success.
- Decide when to cut your losses.
Private investors often hold assets that are losing their value. This relates to what Thaler calls the endowment effect, in which people overvalue the things they own. Also, people feel loss more keenly than gain, which is known in behavioral economics as loss aversion.In private equity real estate, the risk posed by such loss aversion is to hold out for at least a breakeven result, even if that’s unlikely. It requires significant market research, not to mention experience, discipline and foresight, to know when to sell at a time that will maximize profits. A “boots on the ground” strategy and thorough analytics helps real estate asset managers assess markets as they change in order to make optimal decisions. Many investors don’t monitor their deals with this level of attention, which is why they need to make sure their asset manager does.
- Don’t be blinded by your winners or losers.
Private investors tend to congratulate themselves for their successful picks and blame outside influences for their failures. The risk is there’s an opportunity cost to holding an asset when more lucrative alternatives are available, or selling too quickly when market forces suggest it may improve over a certain period of time.An old Wall St. saying applies here: “Bulls make money, bears make money, pigs get slaughtered.” A winner may not be such a winner when compared to other opportunities, and a loser may make a recovery. This goes back to having a process to analyze properties and sticking to it.
- Stay humble.
Real estate investing requires significant expertise in finance and deep local asset knowledge. To make sure your investment decisions involve more discipline than rationalization, it pays to work with experienced real estate management teams that employ a data-driven process.
Bottom line: The best real estate investment strategies start with clear objectives and investors who stick to them. What trips up most investors is the impulse to change paths when they encounter headwinds or to avoid setting goals at all. Following a due diligence process makes it much easier to evaluate deals and also diminishes the irrational exuberance or fear that unravels many real estate investment plans.