In early 2008, the five-year default rate for AAA-rated collateralized debt obligations (CDO) was 0.12 per cent. The Standard & Poor (S&P) rating meant the predicted default occurred only 0.12 per cent of the time, but in late 2008 the default rate came closer to 28 per cent.

This gap between forecast and reality was a gigantic prediction error. In fact, the mortgage-backed securities were extremely sensitive to changes in economic conditions and their defaults triggered the global financial crisis.

At the start of the pandemic, I don’t recall hearing predictions the housing market would be as hot as it is now. In fact, most were pointing in the other direction and there was fear of the unknown.

We expected job losses to drive the economy down, and with it, some adjustment and discount in real estate. Instead, today we see overall debt levels are down (credit card debt and car loans are being paid off and replaced with low-interest mortgages tied to property), and individual debt-to-income ratios are improving while there is a real estate buying spree.

Wrong predictions aren’t new and as the old joke goes, economists called nine out of the last six recessions correctly. So why is it so difficult to make predictions? And what does it mean today for the real estate sector?

There are many reasons why we miss the mark on our predictions – too many to cover in an article, so let’s discuss just two:

– probabilistic vs. fast thinking; and

– failing to prepare to be wrong

Probabilistic vs fast thinking

Daniel Kahneman, in his book Thinking, Fast and Slow (2011), explains two systems of thinking – fast and slow. An oversimplified way of looking at it explains ‘fast’ as quick intuitive gut reactions, and ‘slow’ as analytical evaluations or critical thinking.

Many GameStop investors recently got caught up in the ‘fast’ emotions of seeking quick riches and ignored ‘slow thinking’ fundamentals.  They took a risk on the probability that stock prices would continue to rise “to the moon” based on hype that came after the short squeeze had already happened.

We make most of our decisions with heuristics and emotions and then seek to justify our decisions with a logical reason.

What makes it worse is the abundance of information we now have. The internet has exploded our access to information, social media has decentralized media, and we are now more than ever able to be selective in what information we choose to see.

If we believe in something, we just seek to confirm it by reading only information that supports our view and ignoring that which opposes our beliefs. It is known as confirmation bias.

Reddit users weren’t seeking investment advice that was opposite to their position; they were in a social media-fuelled buying frenzy even after the GameStop stock price multiplied many times over, thinking fast, and getting hyped up on becoming overnight millionaires.

I am talking here about those who saw the stock go from $4 to $300, yet still decided to “invest.”

The emotional tail was wagging the rational dog.

Failing to prepare to be wrong

If S&P had assumed that CDOs were correlated, the impact on the financial industry would not have been as profound and maybe there would have been no global financial crisis of 2007-2008.

In retrospect, the assumption that defaults on some housing would not trigger other defaults seems obviously wrong. If the analysts at S&P had prepared to be wrong on this one assumption, their range of probable default rates would then have been too big to ignore.

And if GameStop investors prepared for an overnight reduction to their investment by 80 per cent, many would not have been in a Wall Street Journal article explaining how they plan to pay off loans they took on for an “investment” – gamble is a better word.

Real estate enthusiasm

Across Canada we are seeing an insatiable appetite for real estate, from homeowners to investors and developers.

That appetite is based on predictions and expectations, but does that mean we could be wrong? Of course. But, it is not that simple.

Traditionally, prices increase more at the core of cities due to urbanization, and then the pressure spills out to the more rural areas. In 2021 we are seeing the opposite because of the pandemic. Urban centre condos are not doing well.

Rental vacancy in Metro Vancouver and Toronto has increased for reasons such as low immigration, remote work, and students studying virtually. At the same time, prices and sales are rising in suburbs and we are seeing a migration of people away from city centres.

We need to admit that we do not know the future of real estate prices or what economic recovery will look like. The government doesn’t know, and neither do the economists and analysts. The economy is so complex that when a butterfly flaps its wings in Brazil, real estate prices go up in Vancouver – chaos theory for real estate.

The years 2006-2007 showed us that when locals start seeing real estate as a “sure thing” investment, and the lending environment allows for speculation, at some point it tips the scales, and our “prediction” of rising prices becomes wrong. We see patterns where none exist and have a very short-term view.

Preparing to be wrong

‘Fast thinking’ in real estate would be to follow the herd and just buy anything. ‘Slow thinking’ suggests making a more disciplined evaluation and preparing to be wrong by asking the right questions – questions that help make our predictions more probabilistic and a little less emotional.

– When are the interest rates likely to increase?

– How quickly do we expect to be back to ‘normal’ at the office?

– What impact will an interest rate increase have on real estate in general?

– What leverage can I handle with my purchase under various scenarios?

And the hard question that really needs to be asked right now is do we expect the current de-urbanization trend to continue post-pandemic?

Once again, we don’t have a crystal ball but if we look at history, we can learn some lessons and make informed decisions. According to economist Ed Glaeser’s comments in Six Hundred Atlantic’s ‘Today, Tomorrow, and COVID-19’ podcast episode (September 2020), despite plagues and pandemics, urbanization has been a constant since the 14th century:

“Urbanization proceeded despite the reappearance of the Black Death in the 1350s. Urbanization proceeded despite the Great Plague of London in the 1660s. All of the great diseases that spread in 19th-century America, cholera, yellow fever, the urbanization just chugged along.

“Even the influenza pandemic of 1919-1920 was followed by a tremendous decade of city building. So, I think our cities have proven to be remarkably resilient.”

As a developer, I am biased toward real estate and think it is the best asset class for my own investments.

We are constantly making predictions, and to make better decisions we rely on detailed pro-forma financial forecasts. This is how our business decides on a “go” or a “pass” for a development project.

For personal investment decisions, I recommend the same analytical approach – whether we are in a pandemic or not. Ask questions, consider many scenarios, base decisions on your financial abilities and, just in case, prepare a downside analysis.

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