“Anchoring” – a Misguided Approach

Is residential real estate in Berlin overpriced? Or are prices reasonable? Or actually quite affordable? There is no other question people ask me as often. I tend to ask back: “Overpriced compared to what?” There is a term used in behavioural economics that is called “anchoring.” It refers to the phenomenon that people tend to orient themselves to baseline values when appraising unknown values, and that their appraisals are influenced are influenced by these baseline values.

Here is an example: Let’s assume you bought stock at a price of ten euros per share. Although this fact is irrelevant for your future decisions (meaning whether to buy more of the same stock, hold it or sell it), chances are that you will take this baseline value as your benchmark.

At the time I bought my single-family detached home in Berlin ten years ago, the vendor had been trying to sell it for two years without success. His anchor value was the original price that he himself had paid at one point – another ten years earlier – and that, at the very least, he sought to recover when selling the house. But the price he had paid in 1994 was twice high as the market price in 2004. Eventually he gave up and sold the house at its market value, meaning for half of what he had originally spent on it.

Job applicants who lost their previous position tend to orient themselves to their previous pay check when entering into salary negotiations with a new employer. “I don’t want to take a step back.” While the sentiment is plausible, what has the salary that you negotiated in an entirely different market situation many years ago to do with the way things are on the market today?

I vividly remember how buyers from Vienna and Copenhagen flocked to Berlin a few years ago to shop for apartment buildings. They felt like in a bargain store. Why? Because yield rates in their native markets, if any, were half of what they were in Berlin at the time. Other investors compares square-metre prices in Berlin with those in other European capitals – such as London or Paris. Having chosen these anchor benchmarks, every offer in Berlin seemed like a great deal.

I also remember doing some “anchoring” of my own: A few years ago, I refrained from buying properties in Berlin-Mitte for net rent multiples of 17 because years earlier I had paid multiples of no more than twelve. And four years ago I would not have dreamt of buying for multiples of eleven in Neukölln where I had come closed a deal for a multiple of 6.8 in 2004. Had I not trusted the misguided anchor in my mind and settled for a rent multiple of eleven back then, I would now be in a position to resell for twice as much.

So what does all this imply? What I am trying to say is that you need to be aware of these subconscious processes when buying or selling. The anchors are misleading. This is true even when conclusions you draw from them happen to be correct. While it may not seem a problem as long as you do the right thing for the wrong reasons, there is no reason to assume that you will be this lucky the next time around.