Understanding the Real Estate Dynamics through Behavioural Economics
In the face of a global housing crisis, the struggle for affordable housing has become a reality not only for Portuguese households but globally. Escalating interest rates worsens the difficulties families face in affording mortgage payments or finding suitable rentals. A recent Eurostat report revealed that, during the last decade, housing prices have gone up by 37% and rents by 16%, underscoring the urgency of this issue. Amidst these challenges, behavioural economics surges as a guiding light, helping us understand the psychological factors that shape decisions in the real estate and housing market.
Traditionally, economic theories operated under the assumption that individuals consistently make rational choices driven by their self-interest and possess perfect information. However, we now know that human decision-making is often marked by irrationality and influenced by various psychological factors. This paradigm shift is of extreme relevance, especially when discussing sectors like the one in this article since it reshapes our understanding of how individuals engage with these markets.
How is the market tricking all of us?
The longstanding advice promoting homeownership as the ideal path, given its equity-building potential, is persistent. Yet, the decision to rent or buy is far from a straightforward equation. Individuals often overlook some of the costs of owning and underestimate the potential of investing the funds saved by opting for a rental.
It is a natural human tendency to overestimate ourselves, especially in areas where our knowledge is limited. The Dunning-Kruger effect complicates matters, as individuals may overestimate their comprehension of complex calculations such as the ones on interest rates, mortgage terms, or property value assessments. This effect may lead to impulsive behaviours and potentially poor financial decisions.
Humans, by nature, tend to follow the crowd, just like flocks. This herd mentality, known as the herding or bandwagon effect, infiltrates the housing market. This effect states that our much-needed careful analysis is often replaced by decision-making based purely on the actions of other individuals. This is particularly dangerous in this market, where large investments are in the middle of the equation, requiring a lot of consideration, as no one wants to throw their money down the drain. Buyers may be tempted to invest, for instance, in specific neighbourhoods simply because others are doing so, perceiving it as a signal of future value appreciation, without any previous careful and deep analysis. Sellers, too, are not immune; the perception of rising property values can trigger a domino effect of property listings that, if significant enough, can cause severe problems in the market.
Lastly, it is interesting to also highlight the impact of the scarcity effect, particularly given its pronounced consequences in recent years. This cognitive bias leads people to place a higher value on an object that is scarce and a lower value on those readily available. In the real estate realm, this translates to homes in high-demand markets selling for more than similar homes in less competitive ones.
The manifestation of the scarcity effect was particularly evident during the Covid-19 pandemic. As homes became multifunctional spaces, accommodating offices and schools, there was a structural increase in the demand for more space. The subsequent scarcity, aggravated by the unique circumstances of the pandemic, significantly affected the supply of new homes, causing a sharp increase in their prices.
According to a survey conducted by Hippo, a home insurance company, over three-fourths of U.S. homeowners who made purchases during the pandemic expressed regret about their decisions. The top reasons mentioned were overspending (30%) and rushing the homebuying process (26%). This situation flawlessly illustrates the inherent irrationality of human decision-making, particularly in times of uncertainty and chaos, where individuals find themselves making decisions that they come to regret in the short term.
How can you avoid being tricked?
Many of the challenges outlined above can be traced back to individuals and their personal biases rather than misguided investment schemes made specifically for falling. It is a challenging task to make people realise they may not know as much as they believe, since no one enjoys being contradicted nor having their ego hurt. To counteract the Dunning-Kruger effect, one effective strategy is to encourage people to test privately their knowledge before making decisions and seek help from industry insiders. Gaining insides from any relevant field is crucial, specifically the ones you anticipate entering! Additionally, approaching information with a degree of skepticism is essential. Realtors tend to highlight the positive aspects of securing commissions, so they may not present the whole picture. Actively seeking diverse opinions allows you to form well-informed judgments about the risks associated with real estate.
Ultimately, being self-aware in regards to the influence of heuristics and biases, and breaking free from automatic decision-making modes, is fundamental, and puts you a few steps ahead of the crowd. It is crucial to remember that relying on heuristics in complex and high-stakes decisions is analogous to taking the wrong turn on a street - a momentary inconvenience when compared to the potentially life-altering consequences of an uninformed decision.
While the prospect of entering the housing market may seem distant for us, young individuals, it is important to acknowledge its significance and inevitability. Whether aiming to simply buy your house, or delve into the real estate realm as an investment, early awareness of this market’s details is essential. Behavioural economics equips individuals with the tools necessary to make informed decisions that align with their financial goals so that, in this ever-changing world of real estate, you don’t get caught in a regrettable decision stemming from a lack of knowledge!
Written by Carolina Martins
Real Estate Speculation and Affordability - BeCurious - beworks https://blog.beworks.com/becurious/real-estate-speculation-and-affordability
Eurostat - Housing statistics" - European Commission, Eurostat https://ec.europa.eu/eurostat/cache/digpub/housing/bloc-2a.html?lang=en
How did herd behaviour contribute to the global financial crisis? - London School of Economics, Central Banking
Buyer’s Remorse Is Rampant Among Pandemic Purchasers - National Association of Realtors https://www.nar.realtor/magazine/real-estate-news/sales-marketing/buyers-remorse-is-rampant-among-pandemic-purchasers
2022 Hippo Housepower Report: How Homeowners Are Responding to Essential Maintenance During - Hippo
Six Cognitive Biases in Real Estate - Altgage
McLaughlin & Dunning: Kruger runs rampant when it comes to real estate - The Aspen Times https://www.aspentimes.com/opinion/mclaughlin-dunning-kruger-runs-rampant-when-it-comes-to-real-estate/