The Psychology of a Decade's Broken Capital Stack

Paul Simon said it: "A man hears what he wants to hear and disregards the rest."

The following isn’t the story of some Sunbelt sponsor raising money from dentists. It’s the story of an entire system, from borrower to lender to securitization desk to institutional buyer, reproducing the same errors at increasing scale. The economics matter, but in a market where so many are trusted with so much, the economics are best read as evidence of the psychology, not a substitute for it.

To the careful observer, the last decade of multifamily real estate teaches more about human psychology than about just real estate. Understand the human behavior at play and how it contributed to our current landscape, and you'll do well in the next cycle.

John Maynard Keynes stated the central problem plainly in The General Theory of Employment, Interest and Money (1936): "The state of long-term expectation... depends not solely on the most probable forecast we can make. It also depends on the confidence with which we make this forecast.” Confidence is useful, but too much can lead to easily avoided mistakes.

In our line of work, navigating broken capital stacks and advising distressed borrowers, we see psychology interplay at every link of the chain. From the tenant writing the rent check to the first responder relying on a pension whose allocator bought the paper, human decision-making and all its fallacies play a role.

The multifamily market that has emerged over the last decade is a case study in how occurrences of success breed confidence, how confidence breeds consensus, and how consensus can go so far as to make over-leverage look creditworthy. Over-leveraging turns mistaken confidence into a real financial problem no amount of structuring can resolve.

Market participants weren't foolish. They behaved in a sequence where each step followed predictably from the one before it, and the pattern compounded so reliably while conditions held that it became hard to correct once distress arrived.

Below, let’s dive into six psychological fallacies that contributed most to our current moment, and explore how better self-awareness might’ve led us down a different path.

1. Self-Attribution Bias

Social-psychology research in the 1970s established that people credit success to their own ability and assign failure to luck or circumstance. In 2001, Simon Gervais and Terrance Odean brought that finding into finance in “Learning to Be Overconfident”, showing that investors don't start out overconfident. Repeated wins inflate their estimate of their own skill, and push them to act more aggressively. Market success can produce overconfidence without improving judgment at all.

In the last cycle, multifamily’s first stages provided a safe sandbox to play in, protected by the planks of favorable interest rates. Operators acquired properties, renovated units, raised rents, refinanced, and repeated. The results were tangible, but not truly earned by virtue of well-managed operations.

Rent growth across the multifamily sector ran roughly 2% to 4% annually before the pandemic (per Callan) and then jumped past 13% to 14% by 2021 and 2022, per Newmark's 2Q22 US Multifamily Capital Markets Report. That move was driven by abundant capital and cap-rate compression, not by any operator's unique ability. From the inside of a deal, skill and market tailwind produce identical results, and we always prefer to believe we’re responsible for our success.

2. The Illusion of Control

Once operators believed in their skills, their confidence swelled such that they believed they could influence things completely outside of their control. Ellen J. Langer and Jane Roth pioneered the illusion of control in 1975 in "Heads I win, Tails It's Chance", showing that people behave as if they can influence outcomes governed by external conditions. “Heads, I'm a multifamily pro. Tails, the market changed.”

Operators can actually control renovation plans, lender selection, leasing strategy, tenant selection and property management. Those are actual levers. The problem is that competence at the property level was extrapolated to exit cap rates, refinancing conditions, renter affordability, and the interest-rate environment. No one governs any of these. But real skill in a narrow domain led to overconfidence that “the market will go our way,” which enabled poor decisions to slide through the cracks.

3. Groupthink

The poorly-placed confidence didn't stop at the sponsor level. It climbed the capital stack, and each layer treated the next layer's actions as validation. Irving Janis coined “groupthink” in "Victims of Groupthink: A Psychological Study of Foreign-Policy Decisions and Fiascoes", analyzing Roosevelt's failure to anticipate Pearl Harbor, Truman's decision to invade North Korea, Kennedy's Bay of Pigs invasion, Johnson's escalation of the Vietnam War, the 1962 Cuban missile crisis, and the Truman administration's development of the Marshall Plan. His insight: cohesive groups under pressure begin to prioritize agreement over analysis. Doubts and questions are suppressed, warning signs are rationalized, and a unanimous decision feels like the correct one.

The multifamily version wasn't limited to sponsor decisions. Bridge lenders financed the strategy through transitional floating-rate loans. CLO managers pooled those loans and sold the exposure. Institutional allocators, including pension-linked capital, increased alternatives exposure materially over the period, creating a broad bid for this paper. Equable Institute's State of Pensions 2021 documented the pension shift into alternatives, including real estate. In December 2021, Invesco published "The Case for US Real Estate Debt", describing a $5 trillion mortgage market in which alternative lenders, particularly debt funds, were steadily gathering shares.

Sponsors, bridge lenders, CLO managers, and institutional buyers all made the same bet: rent growth would run long enough to offset floating-rate debt service and any eventual cap-rate expansion. Rather than betting on the properties themselves, this was a bet on renter affordability, the duration of rent growth, the pace of monetary tightening, the availability of refinancing, and the market's willingness to hold valuation multiples in place.

When the Federal Reserve took rates from effectively zero to 5.25%–5.50% by mid-2023, the shared assumption broke. Many floating-rate multifamily loans had almost no debt-service cushion and, more importantly, almost no value cushion.

4. The Inside View

Even with rates rising, most underwriting kept its focus on the deals on the table, rather than look up at the shifting environment. The inside view was popularized in Daniel Kahneman and Dan Lovallo’s 2003 Harvard Business Review article, "Delusions of Success: How Optimism Undermines Executives' Decisions". The article showed that decision-makers sometimes tended to over-focus on the specifics of their own plan, rather than analyze from the “outside view,” which considers how similar ventures have performed in aggregate. The inside view, thus, is a blind spot that produces optimistic forecasts and understated risk.

Multifamily underwriting over the last decade lived almost entirely in the inside view. Models asked whether a particular sponsor could renovate a particular asset and hit a target rent roll. But nobody modeled what would happen if thousands of sponsors ran the same play at once, or if affordability ceilings capped rent growth, or if a large share of floating-rate loans needed to refinance into a different rate world. Trepp later flagged that roughly 80% of multifamily loans in CRE CLOs were set to mature by the end of 2024.

The outside-view problem, disguised as thousands of inside-view stories, is now common knowledge.

5. Escalation of Commitment

When the multifamily free-ride started to falter, borrowers doubled down on it. Barry Staw introduced the escalation of commitment bias in his 1976 paper "Knee-deep in the big muddy: a study of escalating commitment to a chosen course of action". Similar to the sunk-cost fallacy, Staw’s findings suggested that people commit more resources to a troubled decision precisely because they feel personally responsible for the original choice. Negative feedback intensifies commitment. Staw put it plainly: "The worse the decision maker's prior choice performed, the greater was the tendency to commit additional resources to it."

In multifamily, that’s the workout stage. A distressed borrower usually understands early red flags as a temporary gap to bridge. They petition for another extension, hope for another rate cap, make another capital call; just one more round of persuasion.

The most common version is the forbearance that, inevitably, becomes the plan. Or borrowers refinance into expensive, often recourse-laden hard-money debt, which delays the moment the borrower has to finally concede that original capital structure can't be saved. All while piling on their personal risk.

A maturity extension doesn't raise tenant incomes or reverse a rate shock. Nor does it restore the cap rate assumed at acquisition. Time has value only when time can cure what's broken. When the defect is structural, more time eats away at the remaining equity, reserves, and credibility.

Each step in the workout journey seems rational on its own merits, but together, they’re a way of committing more capital, time, and personal exposure to a thesis the market has already rejected.

6. Cognitive Dissonance

At the end of the distressed episode, the borrower has to reconcile the outcome with a self-image that doesn't accommodate failure. Remember the confidence with which they flung themselves into the multifamily market at the cycle’s start.

Leon Festinger's cognitive dissonance theory holds that when facts and self-conception collide, people revise their interpretation of the facts before they revise their belief about themselves.

Distressed borrowers split along that line. One group thinks the problem requires outside help because the original skill set doesn't transfer cleanly into a distressed negotiation with institutional counterparties. The other group pins failure elsewhere: the lender was unrealistic, the servicer was rigid, the other side didn't understand the asset. Those explanations are often partly true, which is why they're so durable.

Using Psychology To Your Advantage

The art of negotiation involves understanding the above cognitive biases, plus emotions and social communication to shape the back-and-forth bargaining that moves deals. Negotiation is a real skill in commercial real estate, and most operators have solved thorny problems through persistence, relationships, and tactical flexibility. But negotiation works when the problem is a disagreement between parties with room to compromise. It doesn't work when the problem is that the asset can't support its debt — and the operators, clouded by their biases, can’t understand how they got here.

You can't negotiate a counterparty into taking a loss, and you certainly can't do it twice with the same party. You have to prove you're part of the solution rather than the problem. Playing hardball as if you're doing the lender a favor, or presenting the case without proper preparation, buys another round of failure. Depleted reserves and the real cost of hiring competent help then produce repeated attempts to resolve the same problem, rather than a decision to change the decision-maker.

We understand the psychology at play at the heart of distressed deals. Connect with us to learn how we use it to level the restructuring playing field.