Humans are programmed to make snap judgments out of instinct, which leads to prejudices. The majority of us are ignorant of biases that affect the various decisions we make every day. Businesses might also have prejudices depending on the viewpoints of their executives and internal procedures.

For instance, we buy office and multifamily properties when we think we can increase value by making renovations, reducing costs, and changing management. To analyze possible purchases, we adhered to a very rigid approach, but we soon found that we had biases in our thinking that affected the properties we bought. I’ll explain in this post how we changed our asset acquisition procedures to get around these prejudices and make wiser investment choices.

First some backstory. We have acquisition officers that reside in and work in each of our target locations to offer local insight and connections to off-market purchases. To ascertain if a possible asset would be a valuable venture for us and our 600+ investors, our acquisition officers and analysts carefully assess the asset’s area, age, condition, demand drivers, supply risks, growth rates, and predicted price. Additionally, we have a staff dedicated to managing assets, and they will be in charge of carrying out the business strategy for each asset. Collaboration between our asset management and acquisition teams is essential, and both must approve the business strategy for a possible investment.

The majority of opportunities fail to pass our initial screening procedure. Only roughly six homes are purchased annually after we evaluate thousands of transactions. Opportunities that make it past this first screening are then thoroughly examined through site inspections and comparative building analysis utilizing both external data and our in-house research. If an opportunity makes it through the second round, our transaction team will submit a prospective acquisition document and financial statement analysis to our finance committee. Only a few agreements make it this far in the process. For comparison, in 2017 we got over 1,000 offers but only purchased three houses.

Only 20 of the approximately 700 properties passed the initial screening and were reduced to 150 when shown to the whole finance committee.

To eliminate our biases, we looked at many different areas, one of which was how our investment committee hearings analyze possible investments. So, before my colleague and I weigh in, we’ll ensure the entire team can demonstrate their competence. We also discovered that getting further input privately was best practice, as some team members believed they could be most truthful when staying anonymous.

To encourage all acquisition officers and asset managers to invest the necessary time in thoroughly vetting all acquisitions and provide honest feedback, we also connected their remuneration to the overall performance of all deals.

We developed an objective risk model, to further reduce risk while assessing prospects. The deal’s structural risk, and idiosyncratic risk depending on the asset class, city, sub-market, and building features would all be factored into the model. The objective risk model needed to be developed over several months, and assessing the inputs and weights required even longer. We then tested the algorithm on agreements we were currently insuring and the 30 deals we had bought over the previous five years.

The conclusions were astounding; the model correctly forecasted the performance of our structures and their business strategies, and more crucially, it would have stopped us from purchasing our two worst-performing properties. Given the caliber of our staff and our meticulous methodology for transaction research, we were startled by this outcome.

In hindsight, I think that until we used the new model, we were unaware of two biased views that affected our assessment.

Deals Off-Market Aren’t Always Better Than Deals On-Market

First, we had the presumption that unmarketed agreements would ultimately result in higher profits for our investors than those that were advertised. Due to the lesser number of bidders, we reasoned that we would be able to obtain the asset for a cheaper price and ultimately get a larger return on our investment. An illogical mind may find it simple to think that getting a first glimpse at an offer is preferable to having it widely advertised. We discovered that it was not always the reality and that every off-market sale still had to go through the same thorough review as ones that are on the market. But occasionally, it’s to our advantage to be conscious of this bias. Since purchasers occasionally overpay for assets when they believe they have an exclusive chance or overprice the asset without the support of a larger market to assist them to recognize their mistake, we have sold some of our agreements off-market.

Recapitalizations Don’t Always Ensure Profitable Results

The belief that successful joint ventures are guaranteed to provide positive profits was the second prejudice that distorted our evaluation. In many situations, our transaction team obtained advantageous profit sharing and legal rights while recapitalizing the asset for less money than it would fetch through a sale. We must not allow these benefits to divert our attention, though. Even if we can secure the best possible conditions, we need to focus on the deal’s overall risk and return because if earnings are lower than anticipated, investors will only get a sizable portion of a tiny pie.

As we test our risk model with an increasing number of agreements that have been underwritten and back-tested, it will continue to be better. It isn’t to suggest that we don’t appreciate the subjective dialogue and knowledge of our staff; those things continue to be crucial. However, since our risk model can objectively assess every contract without being biased, it will be utilized to assess every transaction.

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Come join us! Email me at mark@dolphinpi.us to find out more about our next real estate investment.