From a small northwestern observatory…

Finance and economics generally focused on real estate

Archive for July 24th, 2020

Seven Biggest Real Estate Mistakes — Part 6

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To bring new readers up to date, I began a series back in the winter on real estate investment mistakes. This was a follow-up to my new book, Real Estate Valuation and Strategy. Before the Covid-19 pandemic, we’d planned on a speaking tour to promote the book, and so these blog posts would serve as the notes. Well, that hasn’t happened yet!

Anyway, let’s get started with today’s entry. (At the end, I’ll give newbies a quick link to the first 5.)

Mistake #6 — Getting Emotionally Involved

I was on Wall Street nearly 40 years ago at the beginning of the “behavioral finance” era. Before then, we considered two investment laws to be sacrosanct: efficient markets and rational expectations. The first law told us that investors, by and large, had good information and made use of that information. The second told us that you couldn’t out-guess the market, because, on the whole, investment prices properly reflected the present value of all future benefits. Over the years, behavioral finance has taught us that both of these so-called “laws” are just wishful thinking. People may have all the information they need, but they make scant use of it. Further, investment prices may wildly vary from true intrinsic values. This is particularly true of real estate, for which prices and values may be two completely different things. Understanding that fundamental truth is key to successful investing.

But why? Why don’t investors properly price assets? Why do they buy assets at the wrong price, or more to the point, why don’t they sell assets (or buy more!) when the prices and values differ? One major reason is emotional involvement. Simply put, people fall in love with something, in this case, an real estate investment. It’s why they overpay for something, and why they fail to dispose of it (or convert to something else) when the values and prices diverge.This doesn’t just happen with individual investors — it also happens with large entities, such as corporations, trusts, pension plans, and the like. Indeed, since the dollars are usually larger with these institutional investors, and the penalties for mistakes aren’t necessarily felt by the people making the mistakes, the corporate screw-ups can be markedly worse. For example:

One shopping center developer had a set of very specific rules for chosing a new site, and fell in love with those rules to the point of ignoring any contra signals. They bankrupted the entire company by choosing a site based on those rules even though there were other signals pointing in exactly the opposite direction.

This problem is probably worse with homeownership, but indeed spreads to commercial property no less frequently. One investor we know accumulated considerable real estate in support of his business interests. He eventually called us in to evaluate his portfolio, and we found that many — perhaps most — of his holdings were no longer useful for his business. The obvious recommendation was to sell and redeploy the cash into more focused and business-related holdings and diversification for his family portfolio. However, the investor had held these properties for so many years, and had come to know the long-term tenants on a near-family basis. In the end, the investor simply held on to a smorgasbord of unrelated properties that required considerably more effort to manage than they were worth.

One long-established and successful family real estate fund dissolved over a minor cash-flow hic-cup. The individual family members did quite well in the dissolution, but were so in love with the family real estate holdings that they ended up in pointless and expensive litigation over the matter.

Of course, emotions often drive investment decisions. We consider family and estate issues, building wealth, and eventual retirement or other goals. All of these are fraught with emotional content. As such, it’s easy to fall in love with an investment, particularly if it has performed well until now. Remember a few adages about investing:

An investment doesn’t care who owns it. Hence, you may fall in love with a particular investment, but it doesn’t love you back!

It’s often easy to brag to friends about particularly attractive or up-scale properties. Nonetheless, less attractive shacks may be better performers, both for income and for capital gains.

Behave like Mr. Spock, not Dr. Spock. The former was a Vulcan who was ruled by logic, not emotion. The latter dealt with cute, cuddly babies. Too often we think of our investments as cute, but we need ruthless Vulcan logic to succeed in real estate.

Before we go, I’d promised to give you links to the first five of these tips. In a couple of weeks, we’ll conclude this series with the seventh and last big mistake. Until then, stay safe, and as always, reach out if you have any questions.

Mistake #1 — Misuse of Leverage

Mistake #2 — Over Paying

Mistake #3 — Not Realizing You Own Real Estate

Mistake #4 — Trying to Catch a Falling Knife

Mistake #5 — Right Property, Wrong Location

Written by johnkilpatrick

July 24, 2020 at 10:14 am

Posted in Uncategorized

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