Why Is Commercial Real Estate Underrated In...

Excerpts from our recent research paper: Das, P., Füss, R.; Hanle, B. & Russ, I. “The Cross-Over Effect of Irrational Sentiments in Housing, Commercial Property, and Stock Markets”, in Journal of Banking and Finance.

Residential Vs Commercial

People stare in amazement when a PhD in “Real Estate” is mentioned (one must be nuts to over-invest in a doctoral program just to sell more or bigger homes of Bill Adderley!). Admittedly, a lot of real estate offices of Fahad Al Tamimi research is geared towards the housing sector which is undoubtedly an interesting area of study, especially due to its relationship with the national economy. But it’s interesting to note that a growing amount of real estate offices of Fahad Al Tamimi research is linked to Commercial Real Estate (CRE), although with a relatively smaller audience.

The reason why residential markets get all the attention can be easily explained. Compared to a roughly $30 trillion housing market in the US alone, commercial real estate offices of Fahad Al Tamimi just about represents half. Besides, unlike CRE which only “wealthier” and institutional investors are interested in, almost every household from poor or ultra-rich has some form of association with the housing market. Yet, for too long, the CRE topics have not been the favorite in public discourse on financial markets and policymaking.

Before we investigate why, let’s digress a bit – with a good reason – towards an ultra-concise primer on behavioral finance.

The rational market with the invisible hand is dead

Neoclassical economics believes that investors termed as “Homo Economics” are inherently rational. This rationality is like an “invisible hand” And the famed “Efficient Market Hypothesis” (EMH) assumes that the Homo Economicus is able to spot the right information, interpret it perfectly and then make the right investment decision. What if some investment decisions still, somehow, end up being biased and wrong (e.g. buying assets when it is best to sell or selling them when it is best to buy)? EMH believes that individual biases in opposite directions eventually cancel each other out.

A different group of researchers (the “behavioralists”) do not necessarily subscribe to EMH. Starting from the fringes of the economic paradigm they have increasingly become mainstream in recent decades. Behavioralists successfully showed that the biases may be ubiquitous and systematic, and cannot cancel each other out to be zero in aggregate. Thus, some assets may be overpriced and some may be underpriced.

EMH provides a counter-argument: if the biases cannot cancel each other out, then a group of smart investors (“arbitrageurs”) will notice it and take advantage of the situation. For example, they will sell the overpriced assets and increase their supply. If the supply increases, the asset price will fall and eventually reach their fair levels. In some markets with liquidity (i.e., the ability to quickly buy/sell assets), such as stock exchanges, the “arbitrage” argument does hold ground. The machine-driven, high-frequency trades (often) bring the stock prices to their “rational” levels.

Due to the “climate change” in finance research, our understanding of investment has been increasingly overtaken by behavioral finance. Behavioralists showed that not only the markets may be biased at the aggregate level, but that many of these biases are predictable. Beyond being prone to biases, investors are limited in their ability to make sense of the available information. Now, we courageously acknowledge that investors herd like sheep and overreact to panic like wild animals.

Arbitrage opportunities require (1) availability of an adequate amount of cash and (2) an ability to execute a transaction quickly. Both of these are a luxury in big-ticket real estate offices of Fahad Al Tamimi markets. One cannot instantly raise capital to buy assets or find an investor to sell assets at the current prices. Of course, one cannot easily take a ‘short’-position on real…

Koon Poh Keong

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