Real estate investors reject a free lunch

Do you indulge in magical thinking? 

You probably don’t want to think so, but many people believe they can influence outcomes that are randomly determined.

Consider games of chance. Ever rolled some dice gently because you wanted a low number? 

If you play the lottery, are you content to take randomly generated numbers? Or do you insist on picking your own? 

Experiments have shown that once someone has picked their lottery ticket, they are reluctant to part with it even if they are offered an alternative with a higher chance of paying out.

Similarly, many of us our more nervous as passengers in cars than as drivers. In general, people believe that accidents are considerably less likely to occur when they are driving than when they are a passenger. 

Such behaviour is driven by the illusion of control – the tendency for people to exaggerate their ability to produce the desired outcome. This is a particular manifestation of people’s tendency to be overconfident.

What does this have to do with real estate investing?

Well, to minimise constraints to good thinking we need to beware of behavioural biases and there is good reason to suspect that investment decision-making in real estate can be influenced by the illusion of control.

Active asset management is an integral part of real estate investing. A key attribute of the asset class is the ability to add value through successful leasing strategies or the innovative repositioning of assets. Unlike many other asset classes, investors in real estate can influence investment outcomes.

And, if you know your market well and have particularly good relationships with local stakeholders, asset management capabilities can be a source of sustainable competitive advantage. 

The danger though, is that investors routinely overestimate their ability to enhance value. Potentially, the illusion of control leads real estate investors to unduly prefer properties where asset management can make more of a difference.

As a result, it is possible that ‘dry’ assets with little scope for asset management are undervalued relative to more asset-management-intensive opportunities.

And there is a chance that investors eschew opportunities where the primary driver of prospective returns is not related to the asset management of the property. 

Consider investing in an office market that is particularly dependent on one industry. Or a hotel adjacent to a proposed, but as yet unbuilt events arena. Or retail assets that will benefit from a potential regeneration initiative. Or residential assets set to benefit from an improvement in local transport infrastructure.

Many investors show undue hesitation about making these kinds of investments. Indeed, some explicitly demand extra compensation through a higher hurdle rate for exposure to such assets. 

For most investors, this makes little sense. The risk associated with a transport infrastructure project opening, a local regeneration scheme going ahead or an events arena being built are all sources of specific risk, as distinct to market risk.

Market risk refers to the systemic factors, such as economic growth, employment levels and interest rates, that tend to affect all properties to a greater or lesser degree. You cannot escape market risk and as such this type of risk does justify a premium return.

Specific risk is different. It relates to factors that are particular to an individual asset. The key to managing specific risk is diversification. 

Diversification reduces or eliminates specific risk from a portfolio. And the more different the sources of specific risk, the fewer assets are required to achieve a good level of diversification.

So real estate investors building portfolios should actively seek assets with distinct risk factors. The faster they combine such assets in a portfolio, the quicker specific risk will be eradicated. 

More generally, large investors should not expect a premium for specific risk factors. In competitive markets, an attempt to do so will see them priced out. 

In less competitive markets, there may be occasions where assets with significant specific risk are available on attractive terms if properly assessed. Potentially small or local property investors may be unable to achieve diversification and would look to sell at an attractive price.

That owning different kinds of assets is less risky than owning only one type should be clear, but the reluctance to invest where asset management skill only has a limited role can limit investors’ willingness to do so. 

It is said that diversification is about as close as you can get to a free lunch in investing. Only magical thinking can make that sound like a bad deal.

A version of this article originally appeared in The Property Chronicle. To read other articles I have written for The Property Chronicle, please click here.