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Part 2 – Lessons of the Downturn

Posted on February 26th, 2010 by John Reeder

In Part 1 of this series of posts, I outlined my general problem with overreliance on models and data to drive decisions in the market.  It’s not that I think models are useless, it’s that I think they have limited use which the model creators rarely recognize. 

I think the poster child example of overconfidence in a model is the low yield, high price tag commercial property.  A property that has a price tag in the high eight figures, or even into the nine figures, and also is accompanied by a low cap rate (supposedly signifying low risk) is the perfect example of spreadsheet jockies who become overconfident in their models and don’t price in the true risk of the investment.  Those deals were common in 2006 and 2007, and are hitting the market today as distressed.  They’ll probably end up trading at a lot closer to what the real risk of ownership is – now that people have had a chance to step back and go “Wait, what the hell were we doing???”.

This post is mostly about using market psychology at least on par with, or ahead of, data and models.  Maybe it’s not accurate to say that I think using psychology is more important than using models.  After all, you need a model to know whether you are in the ballpark or not.  But the analogy that comes to mind is poker.  In poker you need to be able to correctly price out the odds of making your hand, against the odds of your opponent making his/her hand.  That’s the model side.  But you also need to be able to play the game at a psychological level.  When calling a bet, you need to know whether your opponent wants you to call the bet, or whether they would prefer that you fold.  Your read of what you think they want you to do should inform your decision as much as the odds of making your hand.  Additionally, from a timing standpoint you need to be able to survey table psychology to determine whether you should be playing loose or tight, and whether or not your opponents have opened themselves to be bluffed.  So on individual hands, as well as over time, it’s important to have a read on the psychology of those you are playing against.

In real estate it’s equally important to have a read on market psychology.  The cliché goes that if everybody else is selling, you should be buying, and vice versa.  The psychology of the market, and your timing in either buying or selling, is going to determine in a lot of cases whether you do well on a deal.  But on individual deals, it’s also important to have a read on the other party in individual negotiations.  Are you playing them, or are they playing you?  Who is going to end up with the deal that they originally wanted, and who is going to talk themselves into believing that the deal that they got is what they wanted.

On an individual deal basis, I’ve watched guys go to great lengths to ensure that the initiative remained on their side.  They wanted to ensure that they were doing the grinding, not the other way around.  In a deal with a bank, after having agreed to a number of principal deal terms, but confronted with an initial deposit for the escrow that was roughly twice the Buyer preferred number, I watched the Buyer say “thanks but no thanks” and claim to not be interested in the deal anymore.  This Buyer didn’t try to compromise, or simply stick to his number and say that’s all he was willing to do.  He actually just walked away (temporarily).  He came back a few days later and said he would still be willing to do the original initial deposit amount he had proposed.  Keep in mind that this is a totally refundable deposit!  There was no risk involved.  But this guy was not interested in being in a deal unless every deal term was his term.  I learned that it was almost a safety switch he used if he was worried that he was losing initiative.  He just walks away from the deal, totally unafraid he might miss out, and then reengages at a later date.  He would rather miss out on deals than get into one where he felt like the Seller had worked him over.

I have more to add on the psychology of the market, but will save it for Part 3 of this series.

February 26th, 2010 | Category: Uncategorized

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