Human Nature and the Successful Apartment Investor

by | 20 May 2015

In investment pursuits, as prudent as it may seem to follow empirically derived and fundamentally supported conclusions, human nature plays an elemental role. Naturally felt predilections or “notions” are important and often play a critical role in protecting us from potentially adverse outcomes, yet human nature can cloud judgment when not weighed against reason.

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Teetering upon this balance is the key to successful investment outcomes. The current Seattle apartment investment market is experiencing a 30-year bull run and is currently exhibiting trending fundamentals consistent with continued success. Yet, we are at a point in the cycle where concern and skepticism generally enter the investor psyche. As a result, one might expect some investors to pull back, diversify or change course. However, doubling down on previously successful investment strategies with new market entrants following those same strategies is the charted course. Enter the phenomena of “Chasing returns.”

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Chasing Returns 

In the world of equities investment, the theory of “chasing returns” is based on the natural human desire to enter into new investments based on past success of that investment. Although doing so seems reasonable enough, all empirical data proves the falseness of such a strategy in the absence of a forward-looking investment thesis. A prolific and successful institutional investor friend of mine once compared “chasing returns” to changing lanes in traffic in order to “pick the faster lane.” Do we have any forward-looking evidence that the next lane over is faster? Or are we just choosing it because in past moments those cars moved faster than us?

The basis of “chasing returns” is the human desire to follow a path based on past success without a predicted basis in future performance. In every study I have read and every study of someone else’s study I have read on the subject, basing investment decisions on past performance without regard to future fundamentals leads to a loss in total return as compared to investing in the long run.

Applying “chasing returns” to real estate investment is simple. In fact, it is the one of the fundamental pillars of why we have real estate cycles.

Cyclical investor behavior

Real estate markets are well-known to have cycles, generally with very pronounced profitable and painful periods within the cycle. Currently in Seattle, our bull market is spurring more and more investors to the development of new apartment buildings. So far the results have been spectacular.

I have no crystal ball, yet we all know the cycle will end. None of us are sure when it will end, yet now is a time for extra caution and thoughtfulness on how to invest. Although such advice appears prudent enough, many investors are entering the market with investment theses based on current results of bets placed 24 to 36 months ago. Now is a time to think critically about where the market is headed. And doing so requires the guidance of experts and much critical thinking about how to best invest into new segments of the cycle.

Rush into apartment towers, timid start on condo towers

Perceived risk avoidance can often lead to risky behavior. A few weeks ago I wrote a piece titled “Apartment high-rises on the rise in Seattle,” where I discussed the proliferation of apartment towers in Seattle. One (highly anecdotally supported) theory I have for the momentum of apartment tower development is that highly institutionalized capital believes Seattle is a good investment market.

High-rise development is a good mechanism to place large amounts of capital in an efficient fashion. When many groups want to “change lanes” into Seattle, the perception of risk avoidance can lead to the opposite result.

Similar behavior happens in condominium development. There is an adage for the condominium cycle: The first third (of developers) have fantastic performance, the middle third perform acceptably and the final third “get killed.” Guess when most want to invest? The riskiest tranche of the cycle. Our market is off to a slow start regarding condominium development. However, wait and see how market participants react … and perform!

The micro question

The impetus of much of my thinking on how human nature relates to apartment investment is a micro apartment building in the Wedgwood neighborhood of Seattle. It is a very unique and, in this portion of the cycle, a very safe investment. Here are some fundamentals:

  • Rental rates approximately 60 percent of comparable studios
  • Ability to raise rents 7 percent year-over-year for the foreseeable future
  • No competition from 40,000 new units coming online
  • A City Council ordinance amounting to a “monopoly” for current micro apartment owners

Yet, many investors with whom I have spoken actually admitted to wanting the same investment that everyone else is seeking – even citing the perils of doing so given the competition. Conventional apartments have performed so well thus far in the cycle that many investors would rather bet on continued performance than investment in a fundamentally safer asset class. The same human nature that is meant to protect us also exposes us to risk.

Fundamentals, fundamentals and more fundamentals

Conclusion: Real estate investment must always rely on fundamentals. In the mid-2000s, market participants traded aspiration for equity growth for in-place cash flow — to the peril of many balance sheets. We may again be at a precipice in the market.

During episodes in the market such as the one we are currently experiencing, we are reminded of a few timeless truths:

  • Study demand
  • The roar of capital is thunderous yet not always “right”
  • Following everybody else assures as many bad results as good results
  • Cash is king

Above all, more thoughtfulness and critical thinking will dampen cyclical behavior and in the end provide the greatest amount of return. Those bent on chasing returns will chase the market up as well as down.

Dylan Simon is a hobbyist technophile and self-taught urbanist. For more, follow his blog and connect with him on Twitter and LinkedIn.