Fast Decisions in Real Estate

Real estate is a very slow industry. It can take many months or years to begin to see the effects of your decisions. Early activities like stablishing an investment thesis, raising capital, asset selection, and acquisition alone take several months to years. Once in your portfolio, it may take years still for a dominant trajectory of an investment to emerge. Worse still, years into a project an exogenous shock may emerge unpredictably and derail your objectives. 

Collectively, these constraints affect how you think and make decisions. Or at least the factors I've mentioned, and others, have affected my psychology and decision making. I often feel an urge to speed things up. Since our exit is several years away, there's an urge to move quickly. During the calm between transactions we can feel a misleading balance and stability. But time and time again, I see the same emotions creep into my thinking and decision making.

This isn't a treatise on behavior or psychology in investment decisions but rather anecdotes from past, personal experiences. Additionally, I'll look at where I'm most vulnerable and what precautions I take to try to balance irrationality.

Opportunity Cost

I've heard it said, the cost of missing an opportunity may be greater than taking the wrong opportunity. Absolutely wrong. Of all the capital allocators I've come to know in my career, I've encountered someone who has blown up a fund by sitting on the sidelines. While hesitation isn't a trait that's often rewarded, impulsivity is one that's certainly punished.

When we're on the up leg of a transaction, we have unlimited discretion. We can choose to buy; we can choose to wait. We can choose to buy this; we can choose to buy that. Once we're invested, our flexibility is, by definition, constrained and our discretion (in investment decisions) becomes hold or sell. A buyer can buy anything. A seller can only sell the asset under their control. This seems obvious, and to be certain, it is obvious. But the implications are often overlooked. Buyers and sellers are not equals.

Those on the sell side, principally brokers, may pass comments such as "its a buyer's market" or "it’s a seller's market." We're familiar with these cliches. And superficially, they don't seem askew. But the reality is, it is always a buyer's market due to the optionality that a buyer possesses. Nowhere is this more visible than the financial markets where the option buyer pays a premium for a right (optionality) and the seller receives a premium for the conveyance of a right. This relationship is an economic identity and is always present in all markets, real estate included.

It may feel at times that opportunity cost is sitting on the sidelines when assets soar. But this is just an emotional response. If you're liquid, you likely haven't forgone any significant opportunity. A far steeper opportunity cost is entering an investment only to realize down the road we should be in another or none.

That said, we make our money by transacting. Eventually you must jump in the pond.

Transaction Cost

Transactions costs associated with buying and selling commercial real estate are quite large relative to more liquid investments. Brokers take a couple points up and down on the deal and there's often a point or more associated with your debt depending on how it was sourced. Because of this friction, we're motivated to spread the transactional costs over as long of a period as possible. Lockups and expected duration have as much to do with the allocation of these costs as anything else. However, this is a trap. If an exit is warranted, then exit. The avoidance of cost is likely smaller in magnitude than changes in valuation. Because of this, I try to manage how much I allow transaction costs affect entries and exits.

Then there are pre-payment penalties to the debt you've structured. When you have prepayment penalties, especially a sinking prepay, there's a motivation to anticipate transacting when the penalty is at its lowest. This structure, along with other transactions can have a very real influence over timing. Rather than have a sinking penalty, perhaps explore if your lender will take the average penalty as a constant for every year aside from maturity.

It’s nice to think that fundamentals drive our investment decisions. But transactions costs can and will affect your timing if you're not careful. See how you can structure your investments or approach to minimize the psychological impact of these costs.

Reputational Cost

Not only are the emotional pressures intrinsic to the investments, but there's also substantial social pressure. Remaining on the sidelines when assets are rapidly increasing in value can be a very painful position to be in. Your investors want to know why their capital isn't being deployed. When your peers are allocated, this feeling of being left behind is exacerbated.

But remember, although you may appear to be a loser when assets are rising, you'll also be a hero when assets are falling, and you've managed to maintain the integrity of decision making. Of course, that would necessitate that your assessment of market direction was correct to begin with. Which, it probably isn't.

Final Thoughts

I've mentioned above just three different situations where emotional bias may creep into decision making and influence actions. We're emotional creatures and numerous other vulnerabilities exist for emotions to hijack the rational mind. First and foremost, be aware of where you as an individual are most vulnerable to misstep. Then, structure your investments where possible to accommodate your weaknesses, such as the even prepayment penalty example I mentioned above. You can't eliminate the influence of emotions on decisions, but you can work to be more self-aware and manage biases when they appear.