Loss Aversion and Commercial Real Estate

Photo by Aedrian Salazar on Unsplash

What gets you more excited: Netting $800 a month in rental income while increasing equity in a million-dollar property, or the possibility of losing $4,000 per month, due to an unanticipated vacancy? Decades of research suggest that it may not even be close. Losses really do hurt. Not only can they get you in the pocketbook, but they can disproportionately wield psychological pain as well.

I recently reread the behavioral-economics classic, Thinking: Fast and Slow, by the late cognitive scientist and Nobel Prize winner Daniel Kahneman, and it got me thinking about loss aversion and its role in commercial real estate. Loss aversion describes the tendency of individuals to prefer avoiding losses over acquiring equivalent gains. This phenomenon suggests that the pain of losing is psychologically more powerful than the pleasure of gaining. In the context of commercial real estate, loss aversion is playing a significant role in decision-making processes and notably influencing market trends and behaviors.

Overpricing Properties

Over the last couple years, we’ve witnessed sellers who have stubbornly clung to high asking prices, despite buyers’ unwillingness (or just plain inability) to get deals done. According to them, their property should still be worth x, and someone will eventually come along and be willing to pony up. But the fact of the matter is that many investors have tried to make deals pencil at 2023 and beyond pricing, and it just hasn’t worked. When deals have gotten done, they’ve been happening after multiple extensions, retrades, and exorbitantly long due-diligence periods. Part of the problem is that owners perceive price reductions—even when they yield exceptional gains upon disposition—as losses.

Hesitancy to Invest

Under normal market conditions (if there is such a thing), some cautious investors are always going to shy away from opportunities due to the fear of a downtown or uncertainty of returns, which can contribute to a stagnation in market activity. During the runaway inflation and quick uptick in borrowing rates of the last couple years, we’ve seen a disproportionate number of investors sitting on the sidelines, waiting to see what’s going to happen on a macro level. Initially, this made sense. But as stability returns to monetary policy and as prices for some commercial properties begin to dip, eventually there’s going to be an opportunity cost for delaying new investment for too long.

A Costar search at the time of writing yielded multiple office listings in the Nashville market with published cap rates around 7%, and the average cap rate for office sales during the previous 12 months has been 6.9%. And in retail, where you have low inventory and lease vacancy sitting at 3.3%, the cap rates are lower, sure, but even that average has crept up to a 6.2% cap.

Clearly there are opportunities both on and off market to put capital to work in commercial real estate.

Bridging the Gap

As a buyer, you can always insist on waiting to see a couple rate cuts before making a move, and as a seller, you can hold tightly to your price, “until the market catches up.” And as buyer or seller, you can let the fear of loss—loss of the best deal possible; loss of precious dry powder—keep you from making good, solid deals. No one wants to move first. But you know what they say? It’s too soon up until the point that it’s too late. If you’re an investor in buying mode, find a deal that has potential and get engaged while rates are historically normal and competition is thin. And if you’re a seller, quit being stubborn about holding onto 2021 pricing, and dispose of your property at a number that makes sense, based on your investment and what is a clear win for you.