Wednesday, October 04, 2006

 

So, If You Are So Smart... How Come You Are Not Rich?

Spotlighting emotion in real estate investing.

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Much of the grief all of us experience, at one time or another, as real estate investors is self-inflicted. Especially these days, when markets are cooling off. This is by no means a personality trait exclusive to those operating in real estate, as I know of quite a few people who are equally frustrated with the performance of stock markets as well.

The problem is that we are, well … human. Just human. Being human simply means that we all have feelings, attitudes, desires, beliefs and biases and that, furthermore, we are even too capable of judging and second-guessing. The cleverest of us can even third-guess! Furthermore, we all come to the investment arena from different walks of life, even within the same country, and are accustomed to model our decisions on past experiences, for good or bad.

It can be safely stated, as a matter of fact, that real estate is made more of emotions than logic, more of fiction than reality. How else would anyone otherwise explain the urgent, uncontrollable desire of a Buyer to pay for the interest in a real property several thousand dollars more than what the Seller paid just a few years ago? Emotions certainly play a major role in investing. So important is this role, in fact, that if we want to be successful investors we must understand what motivates us, as well as how the emotions of others move the real estate markets. I am not making this one up: learning emotions and understanding motivation is taught in pretty much all real estate schools, as well as by all those who spend their time couching Realtors.

We know, for example, that while at present real estate markets are on their way down, in the longer run there is a rhythm to them. Over time they move up and down, partially in recognition of the fundamental value that moves each and every capitalistic market – the equilibrium between supply and demand. But partly, also, according to how you, I and all of us feel about the future, that is whether we are optimistic that prices will reach new heights or feel, instead, that they will sink all the way down to the bottom of the ocean. Obviously, when the feeling is good we continue to invest and prices continue to rise. When the love affair ends, the sell-off begins and prices naturally decline, sometimes precipitously. The question of the year then becomes: what causes the sentiment to change?

Well, quite frankly, it is normally not the real value of the investments themselves that changes. This is so, because it is difficult to believe that what was once a good investment suddenly has gone bad, for whatever mystical reason. How sure am I of this? Very simple. If the real estate market drops ten, fifteen or even twenty percent in a very short time, does this means that the property we bought has depreciated that much over the same short lapse of time? That we have been so careless, negligent would be a better word, to use, abuse and misuse our own very dear real capital asset to the extent that rather than ordinary wear and tear, we have inflicted on it extraordinary wear and tear, to the point of shaving thousands of dollars off its resale value? Of course not.

The price of a real estate capital asset fluctuates quite a bit over time, but the core, underlying economic value of the asset itself seldom shifts so dramatically. What really changes is our perception of whether prices are too high or too low, combined with the degree of motivation to buy.

In Economics, the ratio of the perceived value of a capital asset vis-a-vis its intrinsic risk of acquisition is termed ‘worth’. Clearly the lower the risk, the higher the worth. It follows, therefore, that the perceived value – or simply ‘value’ - of a real capital asset is the total monetary worth obtained by reducing exposure to risk and liability. Put in elementary terms, ‘value’ is the total net benefit an investor expects to receive from a purchase, measured in currency. The measure of the ‘value in exchange’ of the real estate transaction is the sales price.

In a free market such as real estate, defined as a market where there are large numbers of rational, profit-maximizers, actively-competing participants, with each trying to predict future market values of individual investments and where important current information is almost freely available to all participants, competition leads to a situation where, at any point in time, actual sales prices will be a good estimate of value. It follows, therefore, that sales prices of transactions past are the best measure of value of transactions to come. And of course, if prior sales prices are on their way down, future sales prices will follow the same pattern.

Naturally, when the general sentiment shifts, the market changes direction. Knowing that this is what is going on in real estate at any given time allows us to construct long-term strategies unique to ourselves, to our goals and objectives, that give us the confidence necessary to ride out the plunges during market deflation, and temper our euphoria in times of market expansion.

The secret to make it in real estate, just as in any other market, is ‘to resist the call of the crowd’. Objective analysis and knowledge, coupled by experience, will get anyone a lot farther than the chatter and hearsay so very common in real estate these days. There are as many opinions out there of what is going to happen as there are so-called experts. Some of those opinions border with nothing short of witchcraft … yes, witchcraft. Like the opinion I have read a few days ago authored by a New York stockbroker (no wonder), who predicts a real estate market crash beginning in 2011, which will last all the way through 2023! I am not a high-flying, hot-shot Wall Street analyst – just an average guy who has spent the last nineteen years selling real estate, and buying it. Throughout all these many years I have witnessed personally that real property values have always gone up in the long-run, notwithstanding the numerous ups and downs the industry has been going through. And that is good enough for me.

John Marks Templeton (1912), the American billionaire, was absolutely correct when he pointed out as the secret of his success that “understanding other people’s emotions is critical to investment success”. And Mark Twain (1835–1910), the American humorist, perhaps put it even better when he said: “Let us be thankful for the fools. Without them, the rest of us could not succeed”.

But nobody surpasses the teachings of Dante Alighieri (1265–1321), the famous Florentine poet, who some seven hundred years ago described in the Divine Comedy his metaphorical tour of duty of the Inferno (Hell), guided by Virgil. At one point the two pass through the place where the lost souls of the sorcerers, liars, false prophets and yes ... politicians are held. The spirits of the damned are immersed into a boiling lake of sewage and excrement, and are poked continually and endlessly by devils armed with tridents. Notwithstanding their eternal punishment, these souls still try to capture Dante’s attention and attempt to thwart him from the path of justice, truth and righteousness. Seeing how shaken, weak and feeble Dante becomes for what the damned tell him, Virgil thunders: “Do not care about them - just look and walk!

Luigi Frascati

luigi@dccnet.com

www.luigifrascati.com



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