At some point in the recent past, most of our families have wanted to, or actually have, invested in real estate. For a large part of middle-class families in developed and developing economies of the world, real estate appears to be a worthy investment, often yielding positive returns. However, real estate has indeed been studied for decades, and as many of you might already know, it has created some disastrous bubbles and crises (looking at you, 2007-08).

Let us begin with Japan. A beautiful country with a very developed economy, and with people who mostly invested in their local markets only. In the period 1986-91, real estate (and the stock market) were a part of a massive bubble. The bursting of this ‘Japanese asset price bubble’ resulted in the stagnation of the Japanese economy, a phenomenon which has since then been studied carefully by economists all around the world. (In fact, a lot of American economists feared, and still fear, a similar stagnation in USA’s economy, something which only time can tell).

The effect of this bubble is still seen in the Japanese economy. To put a rough estimate as to how inflated real estate prices had gone during the late 80s in Japan, it is said that the cost of the land beneath the Imperial Palace in Japan was equivalent to the cost of the entire land of Canada, or the entire land in California for that matter.

For a country that has a scarcity of natural resources, such massive inflation was clearly going to result in a bubble burst sooner or later (yeah, it’s not like you’re going to find oil under the Imperial Palace all of a sudden).

Nope, no oil here.

Coming to the most famous economic crisis in recent history, the 2007-08 Global financial crisis was also (in part) caused by a real estate disaster. Many people recall investing in real estate because it was ‘going up at 9% a year’ and the investment just seemed fool-proof to everyone who had the money.

And here’s where the problem arises. People and their mistakes in investment. Behavioural finance researchers have studied all possible economic crises of recent history and explained why they were caused. As intuitive as these principles might seem, experimental economics has suggested that even the most knowledgeable financial advisors, students and managers make such predictable mistakes, resulting in a bubble. (In fact, financial advisors have sometimes been found to make greater bubbles than other categories). But the size of a bubble always depends on the knowledge the sample population possesses about the situation and prospects of investment.

So why is real estate investment such a big deal?

Because of the population. As mentioned earlier, real estate is dominated by players like you and me, who are non-institutional investors and often don’t use the most precise financial calculations to predict the growth and possibilities of our investment. And when you’re not using science to invest, you fall prey to predictable irrational behaviour.

Two of such predictable mistakes or biases are loss aversion and confirmation bias. Why confirmation bias is important in the study of bubbles is because it refers to our behavior of only noticing the information (or news) that is in support of our claims or misconceptions. For non-institutional investors in real estate, this is the most common reason for buying and selling at probably the wrong times, resulting in massive bubbles and losses for all the parties involved.

Anxious buyers don’t make the most rational choices

But here’s the interesting part about real estate, which I like to compare to static friction. Under normal circumstances, any investor consumes a lot of information before buying or selling his or her real estate asset. With or without confirmation bias, there is a point only after which people decide to sell their asset (and can successfully sell it, just wanting to sell is not enough). This could be something to do with the market, or in fact, even the properties of the real estate asset. For example, let us say you own a plot of land at an enclave with hundreds of other plots owned by plot owners like you. The plot needs some basic amenities and the market needs enough flow for you to be able to sell your plot in case that is what you want. This basic requirement is like static friction in physics. You need to conquer it to trigger a potential domino effect of selling plots in the enclave.

Loss aversion plays a very interesting role in such a scenario. Given you want to sell your plot, and the stars have aligned to enable your sale, you might trigger that domino effect. Unless (and that’s a big unless), the prices drop significantly enough for other plot owners to not sell the plot for the fear of loss. Another possibility is that the prices don’t fall enough, and people feel they have a chance to derive positive returns from their investment, in that case, we either have a bubble or a massive domino effect. Now comes another principle of physics, inertia. It basically refers to the resistance to change by an entity. Once a domino effect is triggered in real estate, the common real estate owners are bound to get a nudge to follow suit, and it becomes close to impossible to then change the state of things. This has led to massive crises in the past.

But now you may ask why we care so much about real estate?

As I mentioned earlier, the real estate market is dominated by non-institutional investors like you and me, making mistakes (sometimes massive mistakes) while selling or purchasing real estate assets. This is exactly why a large portion of loan defaulters consider their real estate assets to have turned into liabilities, or basically just bad investments. Studying real estate can give us direct insight into the kind of mistakes we make and the situations that provoke those mistakes, and behavioural economists have utilised it to a great extent so far. Despite being such an important sector in any economy, the real estate market couldn’t have been further from the ideal.

When the dot com bubble burst in the late nineties and early 2000s, investors believed that they could make no further mistakes, they had learnt their lessons, and now there could be no possible bubbles. And only 7 to 8 years later we had one of the most challenging financial crises of all time. The industry changed, but people and their mistakes remained constant. That explains why our efforts in understanding mistakes in a prominent industry might help us prevent unwanted results.

Do you think cryptocurrency is also a bubble (especially with currencies like Bitcoin, whose value has been challenged a lot in the recent past)?

Thanks for reading! I hope you’ve enjoyed reading this article. You can find me on Linkedin and GitHub.