Decoding the Power of Prospect Theory

[Joshua Michael Hauman]

By understanding how investors perceive gains and losses, as well as their sensitivity to different framing and reference points, you can effectively communicate the potential benefits and manage the perceived risks, ultimately increasing your chances of attracting capital for your real estate projects or landing a deal. Of course, as a wise steward of capital this benefits ethical syndicators by helping their investors make more rational decisions.

What is Prospect theory:

Prospect theory suggests that individuals prioritize perceived gains over perceived losses when making decisions. This is also closely related to "loss-aversion," people tend to choose options framed in terms of potential gains rather than potential losses, even if the choices are otherwise equal.

An example of this is most people are more likely to take a guaranteed $100 rather than a 50/50 chance at winning $200 even though the probability is equivalent.

Olympic Study Example

Another example is the silver and bronze medalist winners at the Olympics. Which athlete do you think was happier, the one with a silver medal around their neck or a bronze?

It may surprise you that in 1995 psychologists conducted a study and observed that the bronze medalists were significantly happier than the silver medalists. I their minds they avoided 4th place and not receiving a medal whereas the silver medalists viewed it as a loss since they “avoided” first place and essentially wore a medal crowing them the first loser.

What can we take away from this knowledge?

Loss Aversion in Real Estate

Understand that real estate investors are often more sensitive to potential losses than gains. This can result in holding onto underperforming properties for longer periods, delaying renovation due to loss of upfront capex or overvaluing properties/ inflating future rent growth to not lose out on a deal. This can also be a difficulty in raising capital as limited partners often resist investing due to potential perceived loss. We see this more when doing development deals rather than buying stabilized assets.

Diminishing Sensitivity

Investors' sensitivity to gains and losses in real estate can diminish as the magnitude of the investment increases. For example, the emotional impact of gaining or losing $10,000 may be more significant for an investor with a smaller portfolio than for someone with a multimillion-dollar real estate portfolio. I’ve found it’s far easier to raise large amounts of capital from select high net worth individuals rather than raising from small retail investors who have, in my experience been more reluctant and take more time to manage.

Reference Points

Investors may evaluate the success of their real estate investments based on a reference point, such as alternative investments like stocks or bonds. If the project you’re working on outperforms alternatives on a risk adjusted basis, highlight this in your pitch and in your quarterly updates to provide a reference point.

Framing Effects

The way real estate investment opportunities are presented or framed can impact investors' decisions. For instance, the perception of risk and potential gains or losses can be influenced by how the investment opportunity is marketed or described. It’s not what you say it’s how you say it. Invest efforts into perfecting your pitch and framing the opportunity. This includes refining your marketing materials, being clear in your speech and dressing the part.

Emotional Impact

Real estate investments can be emotionally charged due to their tangible nature and the significant financial commitment involved. Prospect theory explains how emotions, such as fear, greed, and excitement, can influence investment decisions. These emotions can affect risk perception and lead to impulsive or irrational decision-making. As a savvy investor it’s your responsibility to question your decisions and ensure that you’re not falling victim to your emotions and remain rational.

Conclusion

Hope you found this to be worth the time to read it! I’d love to hear below if you have experience dealing with any of the points I shared above or have anything to add.