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The Dangerous Psychology of Real Estate Investing

By - 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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