Mental Models Applied To Real Estate Investment

“I believe in the discipline of mastering the best of what other people have figured out.” Charlie Munger

A few years ago I came across writings about thought frameworks known as “mental models.” The consummate source of mental models is a book written about Warren Buffett’s partner at Berkshire Hathaway, Charlie Munger, and his many speeches and philosophies called Poor Charlie’s Almanack. Derived from this book, Shane Parrish, Founder of Farnam Street, an online repository and community addressing how to think more clearly and make better decisions, has written several articles and now two books about mental models (The Great Mental Models Volume 1: General Thinking Concepts and The Great Mental Models Volume 2: Physics, Chemistry and Biology ). In these books, Shane capsulizes each mental model and cites examples that reflect the implications of that they represent.

As a thought experiment (a mental model that uses imagination to investigate the nature of things) I wanted to explore how different mental models cited in the books above applied to commercial/investment real estate. The real estate industry has so many different frameworks that most mental models have some application to it. I have listed many of the key models below and have applied them to typical (or not so typical) situations in real estate business transactions or considerations. In future posts I will delve more deeply into some of these and their implications, particularly in context with emerging from the pandemic, and introduce other models that have relevance at that time. If you have thoughts, questions or comments about my interpretations or suggestions, please reply in the comments.

• The map is not the territory – Evaluating a real estate opportunity from a map is only a start. To understand a deal requires going to a site and physically understanding its location and how it fits into its environment on a relative basis. Is its current use the “highest and best” in all aspects?
• Circle of competence – Gaining understanding what I know, what I don’t know and what I need to find out about a property, its situation, its ownership history, and its environment is an incremental process. Expanding this to a generic understanding takes many attempts at executing with successes and failures to grow this circle.
• First Principles Thinking– What are the roots of why something happens or what derives its behavior? In performing due diligence to acquire a property in real estate, investors need to understand why the property’s performance relates to its design, layout, systems, quality of improvements generating demand from a certain quality of tenants. So, when considering the value, getting to the basics about the real estate is fundamental.
• Second-order thinking – Ask what the implications of immediate action or inaction will be beyond the obvious. In real estate investing, will bringing one type of tenant to a property influence the value of the property in any way and will it attract other tenants (i.e. a grocery store to a shopping center)
• Inversion – “Begin with the end in mind” Stephen Covey – Looking at an optimal result with a development or purchase of a property, how can one map a strategy to meet this result?
• Occam’s razor – Look for simple explanations of failures and areas for improvement, as quite often what seems complicated on the surface has an elegant solution. Solving for a traffic circulation problem on a shopping center may have a simple access solution, perhaps.
• Hanlon’s razor – We assume people do their best and when things go seriously wrong, it usually is because of ignorance or lack of information, not usually with malice in intent. Often in a real estate negotiation, a mistake is made unintentionally and the opposing party believes it was malicious. This is usually wrong.
• Relativity – As in the concept that everything in life is relative to perspective. Context is everything. Assessing situations in real estate are all relative to location, timing, perspective, individual situations and motivations. This model creates a market, such that sellers have a different perspective than buyers.
• Inertia – Property owners can get carried away with things or become too comfortable with the status quo (conservation of energy), or they deny what’s going on in the environment. For example, disregarding the impact of the capital markets on the value of a property in making a decision.
• Friction and Viscosity – Often government regulations and opposition from local community groups affect the momentum of real estate development projects. Sometimes, leaders can accelerate progress by making concessions and appealing to the needs of the community, thereby “greasing the skids.”
• Leverage – Beyond hard work, people must keep in mind how things get done within any organization and in life. Leverage is always reciprocal based on a quid pro quo. From a personal relationship perspective, accommodating the needs of others can “leverage” their opportunities for advancement in what they want. In real estate, leverage is applied financially, as well, to increase equity returns up to a point where the risk can be managed. Over leveraging happens when unforeseen risk events occur and the property cannot maintain its stability.
• Activation energy – At a personal level, certain situations in owning or investing in real estate will “activate” someone to buy, sell, refinance, lease or negotiate an issue. It is an internal activation. External activation is created by crises or opportunities that need to be addressed.
• Alloying – In real estate, looking at mixed use properties, the “alloy” of retail, residential and office uses in a project create a synergy that wouldn’t exist otherwise, where retail activates the property where people work and live providing on site convenience and recreation.
• Ecosystem – The ecosystem of real estate is both global and at the individual property level. What drives value in one location has no bearing on another based on its ecosystem’s influence.
• Niches and Hierarchical Organization – Real estate requires both specialization in niches- design, marketing, finance, law, and construction; as well as generalization such as asset management, development and investment. General skills are a niche in themselves. Organizations need to be led by generalists with support and synergy from specialists applying their expertise for the entire organization’s benefit.
• Self-Preservation and Cooperation – Self preservation in real estate is the ability to adapt to changing circumstances and be resourceful in responding with fresh perspectives. Cooperating to accomplish any complex task in real estate investment or development is critical to its success.
• Incentives – The real estate industry is driven by not only financial incentives, but tangible results from design, construction, aesthetics and experience of living, working and playing within it.
• Systems thinking – Each profession in the real estate sector has its system of operations and function. The total cycle of development, the life cycle of a real estate investment, and the evolution of real estate companies all are systemic in nature and require systems thinking. All the components of real estate integrate together into an ecosystem via systems thinking.
• Law of diminishing returns – This comes about constantly in real estate with obsolescence, physical deterioration and overbuilding of a product where demand either flattens or declines.
• Margin of safety – This is accommodated in real estate investing usually through sensitivity analysis to assess risk or setting aside reserves for replacements or capital expenditures.
• Numeracy/Surface Area/Tendency to generalize from small samples – use of statistical and non-statistical sampling. This is applied in market analysis for investing or developing where the aim is to estimate the financial impact of a new acquisition or development from a few comparable properties.
• Opportunity cost – in deciding between two or more investment or development strategies, the effort you put into the chosen endeavor is offset with what could have been achieved with another. This is ongoing with every project in our industry and the choices people make to pursue them.
• Specialization – The real estate industry has a multitude of specialties and with the growth of technology more arising almost daily. Niches are being created to use and apply data that require even more specialization. The industry’s impact affects everyone’s life, so the specialties reach the extent of the imagination.
• Trust – The success and results in the real estate industry is built on trust. Even though documents are necessary to establish ownership and investment interests, the trust among men and women in the industry is essential to conduct business.
• Bias from incentives – This is a common issue in the real estate business where greed and ego can cloud the judgement of operators and investors.
• Tendency to Distort Due to Liking or Disliking – Clearly, people want to do business with people they like, but should view people whom they respect, and may not like as much, even more.
• Denial – This happens frequently in real estate when property owners or investors see a trend, yet think their property won’t be impacted until it is too late. Or, in relationships when you believe that someone will eventually come around and never does.
• Availability heuristic – Quick assessment of salient issues weigh heavily on decision making in real estate investing. Bringing in experience that is not immediately apparent can often allay risk sometimes.
• Narrative instinct – Telling stories is good for context; however, stories need to be supported with evidence when assessing a situation in real estate investing or development.
• Curiosity instinct – Every real estate investment and decision derived from curiosity about a project’s viability or potential.
• First conclusion bias – Important to keep an open mind and keep digging beyond the “first conclusion” as often there are more factors in a real estate decision.
• Tendency to Overgeneralize from Small Samples – Generalization is often a good place to start with tendencies based on a small sample of options. However, each property and situation is different and nuances of location and timing have large impact.
• Influence of stress – Pressure from deadlines and negative surprises affect decision making toward “immediacy” which often is not appropriate and causes error and may have long term implications on property value.
• Survivorship Bias – Success is often attributed to “winners’ skill” and less often to luck or randomness. Losing is often due to bad luck than incompetence or less skill. Real estate projects that are initially successful can be “the right project at the right time” and if built or bought in a different time it might fail.

While this is a summary list of mental model applications, each one of them offer significantly more opportunities to apply into the many facets of real estate investment and development. If I touch a nerve with any of these concepts, please provide comments below or write me at jcoe@coeenterprises.com with your thoughts and questions.