Sunken Costs in Real Estate

Dated: March 14 2019

Views: 466

I would like to share a quick anecdote about the value of your real estate.

My wife and I rented a movie the other night on Xfinity.  The price was $6.99. Once I confirmed the “buy” icon the second time, the money was committed and there is no way to get it back.  Fifteen minutes into the movie we realized it’s was a real stinker. There was no way we were going to enjoy the movie.

“I’m going up stairs to bed,” Gail submits, choosing to fall asleep to a 1950’s Turner Classic Movie instead of enduring more pain with me and this stinker in the living room. 

“Not me, we paid $6.99 for this move, I don’t want to waste it,” exclaims yours truly.  

Really?  And then there is Ron:

Ron leaves home to walk to the convenience store eight blocks away to pick up some aspirin. Six blocks into the walk his wife calls his cell phone to tell him that she just called the convenience store and it’s closed.  Does Ron think, “Well, I invested six blocks in this errand, I might as well continue, I don’t want to waste the six blocks I already invested?  Probably not. 

These two examples may help us understand the principal of sunk cost. A sunk cost is an investment that is unrecoverable.  Sunk costs should not be considered in an investment decision, only prospective (future) costs should.  Traditional economics proposes that decision makers should not let sunk costs influence their decisions. Doing so would not be rationally assessing a decision exclusively on its own merits. 

“I’m here watching this movie, is my time better spent reading or watching the movie?”  The cost will be an investment of time of the next minutes. Not the $6.99 that is already gone.

Human behavior, however, often considers past investments in current decisions.  Many times I hear, “But I have paid “so much” for this house!, often disregarding opportunity costs versus the cost of “hanging on”. 

Let us use a real estate example.  The Lennon’s purchased a home in 2006 for $320,000.  (2006 was a bad time to buy!) They put up $70,000 so their mortgage is now $230,000.  A reliable agent tells them that the market value on their home is $225,000. They can buy a new home today, near the school their son goes to, with the fourth bedroom they need, for $225,000. The mortgage rate on their existing home is 7% and it  is only 4% mortgage for the new home; but would have to write a check at closing (or short sale their home). 

Here is a very key point:  What they paid for their existing home has absolutely no bearing on its value.  A rational decision would be to evaluate the cost of the move based on future costs:  The down payment and mortgage to buy the new home, plus the cost of the shortage on their existing home -  against the gain of a newer bigger home that is where they want it to be. They should not count the $70,000 already sunk, the payments they made the last 7 years, (sunk), but the future cost to them. The future mortgage payments, the lower energy bills, and the lower cost of maintenance are what should be important to the Lennon family, not what they have sunk into their old house. 

What you paid for your home has zero influence on what it is worth. If you inherited a building, you would not ask less for it because of your low cost, why would you expect someone to pay more just because you overpaid? 

There are two other factors in Sunk Cost that are interesting. The first is called Overly Optimistic Probability Bias. Once a person has invested time or money in something, they may have an unrealistic opinion of its worth or chance for success. Just ask someone that just bought a lottery ticket if they will buy an additional one, “no thanks” they offer; they have become confident of their own ticket winning.

Top real estate agents see over optimistic probability almost every time we talk to an owner about selling their home . This phenomenon is also called The Endowment Effect.  The person demands more to give up an object then they would be willing to pay to acquire it.  Sound familiar? 

{FirstName}, the second factor in play in the Sunk Cost theory is the Personal Responsibility Requisite.
I was the one that wanted that movie mentioned above that was a stinker, darn if I was going to give it up! In real estate the personal responsibility factor has more facets – like personally guaranteeing on a loan – a promise was made – and ethical and moral and indeed legal issues arise. 

In real estate I have advised looking at alternatives when making a decision, and the purpose of this article is to emphasize that alternatives to holding onto a property should not be influenced by dollars and time already sunk, but only future cost/value issues, What you paid for your home has zero bearing on what someone else for pay for it.  

Don’t hold onto your home or an other investment at the cost of moving forward and having more enjoyment or a higher return because of cost.  In many instances a new home or newer building on the fresh start of an appreciation curve will be a wiser decision than sticking with a property because of a sunken investment or a misguided desire to punish yourself for making that over investment in the past. 

Can I help you sell your home?  Do you have Money you want to take from the market and put in real estate?

Call me. I can help. 

 

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Gregg Fous

Real estate has been my passion since I took my first Al Lowery class on real estate investing in the 1970’s. I vowed during that class that I would buy one property a year. Over the next five ....

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