Loss aversion and anchoring in commercial real estate pricing: Empirical evidence and price index implications

We consider two famous phenomena from behavioral economics: loss aversion (based on prospect theory), and anchoring, for the role they played in the pricing of commercial property in the U.S. during the 2000s decade. We find that loss aversion played a major role, approximately as big as was found by Genesove & Mayer in their 2001 study of the 1990s Boston housing market. We also find that more experienced investors, and larger more sophisticated investment institutions, exhibit at least as much loss aversion behavior as less experienced or smaller firms. We extend earlier research by examining how behavior changes in different market environments during the dramatic cycle of 2001-09, and discover that loss aversion operated most strongly during the cycle peak and turning point in 2007, and then became virtually ineffective during the extremely severe drop in the demand side of the market during the 2008-09 crash. We extend previous work by developing longitudinal price indices of the U.S. commercial property market that control for, and explicitly incorporate, the behavioral phenomena we have modeled. From an econometric methodology perspective, these price indices suggest that controlling for behavioral phenomena can be quite important for developing successful hedonic price indices. The indices also suggest that, while the behavioral phenomena are important at the individual property level, the impact of the psychological loss aversion behavior reflective of prospect theory was sufficiently attenuated at the aggregate market level such that the pricing and volume cycle in the U.S. commercial property market during 2001-09 was little affected by it. However, we document substantial strategic pricing differences between sellers facing a gain compared to sellers facing a loss, consistent with a strategy to sell winners and hold onto losers, with the extent of the pricing difference varying longitudinally across the market cycle. ∗ The authors are both with the MIT Center for Real Estate, Commercial Real Estate Data Laboratory, 77 Massachusetts Ave, Cambridge MA 02139. The authors thank Real Capital Analytics Inc (RCA) and Real Estate Research Institute (RERI), for respectively providing data and the financial support for this paper. Geltner is the contact author, at [email protected] (phone 617-253-8308, fax 617-2586991).