I just read an interesting chapter from Tim Smith’s book, "Pricing Strategy: Setting Price Levels, Managing Price Discounts and Establishing Price Structures." It’s Chapter 5: Psychological Influences on Price Sensitivity.
The chapter covers a number of pricing phenomenons, such as why prices ending in .99 tend to convey a discount and why whole prices ending in 0 tend to speak more to quality. It’s for this reason that art work is typically priced using simple round numbers.
But one of most interesting theories from the chapter is that of Prospect Theory. Not only because of its impact on pricing strategies, but because, I think, it also applies to the real estate development business.
Prospect Theory essentially describes the way people make decisions in the face of uncertainty. The two big takeaways for me are (1) that potential losses carry more weight than potential gains and (2) that both losses and gains experience diminishing returns.
What this effectively means is that people, when faced with risk, tend to focus more on the negatives, and the potential losses, than on the positives. This means that the gains just can’t match the losses, they have to be significantly greater if you’re going to inspire action (a purchasing decision, a change in behaviour, or whatever).
The second point basically means that these gains and losses become muted after a certain point. If you hit someone with enough of either, eventually they reach a point where they become desensitized in a way. Each additional amount of gain or loss produces less and less impact.
Besides the obvious point of making sure that your product or service results in lots of gain for your customer, there are a couple of other things you can do to respond to this theory.
The first is to “bundle losses” and “unbundle gains”. In other words, hit people with all the losses at once and then spread out the gains. What this does is maximize the psychological perception of gains and minimize the perception of losses because, remember, after a while people start to discount the losses.
The other thing you can do is transfer losses, which is often just the cost itself, from direct to indirect. Big box stores, as an example, are great at this. They offer low prices (a direct cost) in exchange for greater indirect costs: higher transportation costs to the user, greater environmental impact, and so on. Studies show that people feel direct costs much more than indirect costs.
There are a bunch of things you can do based on this theory, but again, one of the most fascinating things for me was how it also applies to the real estate industry. There’s a well known acronym in the industry called NIMBY. It stands for Not In My Back Yard, and it’s used pejoratively to refer to people who oppose development in their community.
However, if you look at NIMBY’ism through the lens of Prospect Theory, you realize that it’s almost an innate human reaction. Development and construction is disruptive and the end result is change in somebody’s community. And I suspect that most residents view it as a risky and uncertain situation. Therefore, it’s no wonder that they’re first reaction is opposition. They’re weighing the potential losses more than the potential gains.
So maybe we developers just need to apply a little Prospect Theory. We need to get better at producing and communicating gains.
This past Friday, Paul Reichmann passed away in Toronto. He was 83. For those in the real estate business, Paul was a legend. He was the developer behind landmark office projects such as First Canadian Place in Toronto, World Financial Center in New York and Canary Wharf in London.
He was the man behind Olympia & York, which by the late 80s was one of the largest real estate development firms in the world, making the Reichmann family the 7th richest family in the world. Their net worth reached $12.8 billion at its peak. In 1990 they owned 8% of New York’s commercial office space. This was more than twice as much as the Rockefellers.
But what makes the Reichmann story so fascinating is the beginning and end of it.
Paul was born in Vienna, but his family fled the Nazis and came to Toronto like many others at the time. He and his brothers setup a tiling company called Olympia Tile and its this business that eventually led them into real estate.
Paul became known for taking on huge risks. He believed firmly in the principles of risk and reward.
I remember when I was at Penn hearing stories about Olympia & York from the Dean at the time, Gary Hack (a Canadian). He used to tell us about the phenomenal amounts of leverage that O&Y used to take on in order to scale.
But ultimately it was this leverage that brought them down. In 1992, Olympia & York went bankrupt and the family was left with a net worth of less than $100 million. Still a great sum of money, but nowhere near the $12.8 billion they once had. The New York Times called it “one of the most astonishing financial collapses in history.”
But in many ways, this is not an uncommon developer story. Real estate development is risky. And Paul did eventually rebuild. Not to where he was before, but he did come back. He became Chairman of Canary Wharf in London and went on to develop the tallest tower in Latin America.
Last week Toronto lost one of its most prolific real estate minds. Paul was also largely part of an era that no longer exists. The real estate business in the 80s wasn’t as institutionalized as it is today. It was filled with larger than life individuals, such as Paul, taking on huge personal risks. It must have been an exciting time to be in real estate.
Thanks for everything you’ve done for Toronto, Paul.
Atlantic Cities just posted an article on the world’s 5 largest housing bubbles. In descending order of real growth, they are:
Israel
Norway
Switzerland
Canada
Germany
Not surprisingly, Canada is on the list. There is, of course, lots of talk both locally and abroad about the stability and sustainability of our housing market. Here’s what the article had to say about Canada:
"With real home price appreciation near 20 percent, Canada’s home price growth has been raising eyebrows. Bank of Canada governor Stephen Poloz doesn’t see a bubble, but others aren’t so sure. Climbing alongside housing prices have been levels of household debt, which surmounted 165 percent of income in the second quarter of 2013. (That’s not too far from where they were in the U.S. before it suffered its housing crisis.) And the Bank of Canada itself has even warned about risks posed by frothy condo sectors in big cities like Toronto. A few hedge funds, such as San Francisco-based Hyphen Partners, have even made high-profile bets on a Canadian housing bust. They haven’t paid off, yet.”
And here’s the full list of countries:
Overall, it’s not surprising to see that Canadian home prices have risen so dramatically since Q1-2009. As the US sank into deep recession (2008-2009), Canadian credit became cheap in order to stave off a recession of our own. This fuelled the housing market, which is an asset class that’s inextricably linked to financing costs.
The same thing happened in Ireland, which today sits at the bottom of the above list. It has seen real prices drop roughly 40% since Q1-2009. By adopting the euro currency, Ireland no longer had control over its own monetary policy (this is one of the downfalls of a centralized currency). So when the economies of the larger continental countries stuttered, interest rates were dropped. For the strong Irish economy, it ended up creating a housing bubble.
I worked in Ireland in the summer of 2007 and I remember people telling me about this. Already at this point there was concern that the market had become overheated. There are obvious parallels to what has happened in Canada, even though we don’t share a common currency. The Canadian and US economies are inextricably linked.
So will the same thing that happened to Ireland happen here in Canada? Nobody knows for sure, but I think we can take comfort in the actions taken by the feds to tighten up lending. They’re acutely aware of what easy credit has done to the housing market and they’re trying to temper it. And it’s certainly had an impact.
Early this week when I was on the panel about investing in condominiums, I asked a lot of the realtors about what they were seeing in the residential marketplace. A great number of them told me that their clients were struggling to obtain financing. A lot of deals were falling through because of it.
If you’re worried about our housing market, this should be taken as great news. Choke off credit and you choke off real estate.