Real estate valuation – pschyological baises

November 20, 2007

I think there are several psychological baises working in case of real estate. The first is incentive caused bais. Typically real estate is sold via brokers or by sales agents of the builder. They have an incentive to sell the property and typically earn a commision based on sale price. It is quite obvious that the broker or sales agent would be motivated to sell at as high price as possible. In addition it is likely that he will give you a bullish outlook for the property prices.

The second strong bias is social- proof and deprival super reaction tendency. You see you friend buy a property and make easy money. At the same if you have not invested money and feel deprival super reaction tendency as everyone one else is making easy money.

So these two tendencies work together and motivate us to look for a property. Combine this with the incentive caused bias where the broker is constantly trying to create a scarcity (he will tell you that he has a lot of buyers and if you don’t buy now  you may regret as the price will go up), lack of information and overoptimism on our part and this creates a combined effect. All these factors add up and can cause the buyer to become irrational.

I personally think the risk of bubbles are higher in real estate for the following reasons

  • the common notion that real estate cannot lose value and represent something limited which is land
  • High amount of leverage. Typically loans on a property is around 20%
  • Lack of transparency and information in this market.
  • All the above psychological factors
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