The Dangerous Psychology of Real Estate Investing
By Steve Gillman - 2012
Most people would like to think that they are relatively objective
about their decision making. This is perhaps especially true
when those decisions have to do with real estate investing. We
can easily say things like, "it's all about the numbers,"
but our human psychology does not drop away in favor of a Spock-like
logic when we have to decide whether to buy this condo rental
or that mobile home. We are affected by all sorts of prejudices
and subtle psychological forces. Here are a couple examples,
which can be taken as lesson in what to watch out for if you
want to avoid making too many mistakes.
Real Estate Prejudice
All investors have favorite types of investments based on
past experiences and events that might have been somewhat random,
or based on what we have heard from others. This is certainly
no different with real estate. We come to the game with prejudices
that are difficult to overcome. For example, one of the more
common ones is a prejudice against mobile homes as investments.
As explained on our page
about investing in mobile homes, you can often build equity
faster with mobiles (as long as you buy them on land), and you
almost always will get better cash flow than with regular houses.
Yet most investors feel that they are somehow a risky investment.
It is true that the management can sometimes be more involved,
as is true with most rentals housing people with low income.
But many investors might put up with a bit more work to get much
higher returns--if their prejudices didn't keep them from looking
at this type of investment property.
If you are familiar with a particular type of real estate
investment and you have done well with it, then it might make
sense to stick with what you know. The biggest gains often come
with the development of some expertise in an area. But if you
are not sure what you want to invest in, don't let your prejudices
prevent you from exploring all the possibilities.
Sunk Cost Fallacy
The science of behavioral economics addresses how we make
decisions involving money. Scientists in this field can list
many ways in which we are less-than-rational. One of the more
common problems we face is what they refer to as the sunk-cost
fallacy. It is our tendency to place too much weight on what
we already have spent when making a decision about the future.
For example, if two people are equally interested in going
to a concert and both have tickets, but one bought his and the
other got them for free, the former is more likely to attend,
even if it is inconvenient when the day arrives. Note that the
money is already spent and he loses nothing more by staying home,
so the expenditure should logically have no relevance to the
decision whether to go or not. But most of us feel compelled
to act according to our previous expenditures; the "sunk
cost."
How does this psychology apply to real estate investing? An
example will make it clear. Suppose you buy a small house with
the idea of fixing it up and selling it for a profit. When you're
done you see that you can sell it for $85,000 and make a profit
of $15,000, but then you suddenly discover a foundation problem
and spend $20,000 on repairs. Now you face losing $5,000 if you
sell. You can rent it out and make $200 monthly cash flow while
you wait a couple years for prices to rise. What should you do?
Of course, there are many factors to consider, and some of
them are personal, so if you ever face this predicament the decision
you make will be based on your unique situation and needs. But
most people would be automatically tempted to wait to sell because
they have already put the money into the property. But consider
a different scenario and you might start to see how this is more
a matter of our psychology than rationality.
You are looking at a $15,000 profit and there is no foundation
problem. But a burglar breaks into your car while you are traveling,
and steals $20,000 in cash you had hidden under your seat. Now,
do you sell or rent the rental house? You might think this is
a strange question because the two things are unrelated, but
in reality you are in the exact same financial situation going
forward. yet selling the house for a profit probably sounds even
better now.
In other words, decisions should rationally be based on our
best guesses about their future value, and not on some attempt
to deny what has already happened. Regardless of what was spent
or what mistakes were made, you have a choice of $85,000 now
or $200 in monthly cash flow while you wait to sell for more
someday. If you were planning (and able) to make $15,000 in profit
on two more real estate investments this year using that money,
wouldn't it make more sense to acknowledge the loss and make
that $30,000 (or $25,000 after your loss on the sale) rather
than the $2,400 you'll net from rent?
This isn't an easy lesson to take to heart. Who wants to lose
money after all? But the money is already lost whether we acknowledge
it with a sale or not. A decision to keep the house means you
are essentially investing $85,000 to get $2,400 in annual cash
flow. We can look at the past as a way to learn valuable lessons,
but we can only affect the future with our current decisions.
Knowing a bit about the psychology of real estate investing
will hopefully inspire more rational decisions and better returns.
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