I’m really proud of that headline. In fact, while you’re sitting here trying to read the post, I’m sitting here wondering if I should submit this post to an academic journal that might publish it simply based on the title of the post. OK, enough clowning.

One of the hardest lessons to learn in real estate is the danger that comes with making market projections based on current demand levels. As market participants we are collectively inflicted with myopia, with some bias towards the upside. In our minds, demand will either continue to be good, or if demand is bad, it will get better. Most of us make plans for the future based on the fundamentals that we see today, unless those fundamentals are bad – in which case we plan for things to get better.

Notice anything missing in this scenario? How about basing our market projections on things getting worse? It’s certainly not possible that things should always stay the same or get better right? And yet we very rarely plan for things to get worse. It’s almost like it’s hardwired into us.

Perhaps a few examples would help. In 2007, the Southern California industrial market was hot. Demand was up, supply was down, and there was a story to go along with the hot market. The reconfiguration of global supply chains was supposed to keep demand for industrial space high even if economic activity were to slow. As a market, we collectively anticipated that demand would remain strong, or get better. The development industry wrote this assumption into their plans. How does the story end? That’s a rhetorical question. I know of three publicly traded REITs that each own well over 250 acres of land – enough to support three million square feet of development each – in the outlying Victor Valley market. How do really smart people make this mistake and acquire a land development pipeline that if built out would be 10X the submarket’s existing supply? Call it selective myopia.

But certainly the industrial developers were not alone in making the mistake. Their mistake might be less forgivable though because they had the benefit of watching residential land developers make the exact same mistake two years earlier. Residential land developers looked at 2005 absorption levels and tried to make sure that they had enough land to support them for two to three years at least. Urban legends abounded that public homebuilders had to show a minimum future land supply in order to satisfy Wall Street, in the same way that car manufacturers have to show a future supply of steel. The story ends the same though. Demand dropped off, a two year supply became a seven year supply, and the market seized up.

Perhaps the kicker to this story is that when industrial got really hot in 2007, the industrial developers went out and bought some of the residential developers out of their bad deals. I distinctly remember talking to a prominent land acquisition guy for an industrial REIT and he was essentially gloating at his firm’s position of being able to buy the residential developers out of their deals. But in the end, the industrial developers were also overextended and into land deals that they had no business in. Two separate groups of developers made the same mistake and in some cases on the same properties!!

As humans, we are almost hardwired to play the upside. Planning for the downside, or even admitting the possibility of its existence isn’t in our DNA. Those interested in the Cliff’s notes version of how this affects our investment mentality can read Malcom Gladwell’s profile of Nassim Taleb. The profile is all the more readable because it was done before Taleb become a rock star in the 2008 financial crisis. That profile is here. http://www.gladwell.com/2002/2002_04_29_a_blowingup.htm

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