In our newsletters we often talk about the issues that come from the complexities of real estate laws, interest rates and the vast variety of loan products that are out there these days. We need to understand all these things to safely buy and invest in property. Today though I want to talk about another complexity that is just as important to remember when dealing in property, the human brain.
It’s called the ‘endowment effect’, and it’s a popular topic of research amongst Psychologists and Behavioural Economists. In short, just having something makes us think it is worth more than we would if we didn’t already have it. This attachment to things we own means we think the items that make up our personal property are more valuable than they really might be. The researcher who first identified the phenomenon was Richard Thaler who in 1980 did an experiment in which he gave coffee mugs to one set of people and asked what they’d sell them for. He asked another group of people what they’d pay for the mug. Keep in mind these weren’t even people’s favourite mugs, just mugs they’d been given. Even so, those contemplating selling asked on average $7 for their mug while those saying what they’d pay for the same mug offered on average $3. The effect is stronger if we own the mug for longer.
In some ways this is a great little trick our brains play on us. We’ll automatically be more happy with most things than we’d thought we’d be, just because we have them. It’s a built in “no regrets” feature and it seems to have evolved to make sure we protect what we have. It’s also exploited by companies offering money back guarantees. They know that just having the blender or espresso machine for a while will ensure satisfaction with them and as a result fewer returns.
So what does this have to do with real estate?
When analysing a valuer’s report with a disappointed client selling their home we invariably hear the statement “one sold next door and it was no where near as nice as ours”. One, perfectly reasonable explanation is that valuers tend to be on the conservative side – firstly because markets rise over time and they base their valuations on past sales, and also because they’re more at risk of being sued for negligence for an over than for an under-valuation. But the endowment effect could also be rattling around there as an explanation? Try to keep this in mind for example when you’re trying to sell and the crowds just don’t seem to realise that your property is as wonderful as you think it is. While you may have reconciled yourself to its weaknesses and just love its attractions, buyers will be more dispassionate. They don’t have the attachment you do and you may need to find a price based on similar properties rather than your feelings.
For the buyer the lesson is more immediate. The endowment effect can take root in your brain remarkably quickly and it’s something that real estate agents play on continually. Sometimes you don’t even have to have bought something, just the idea of buying a certain thing can be enough. You may get attached to a house you’ve inspected and have your heart set on. This may lead you to offer a higher price, quite understandable. However if you are a little tight on deposit or equity remember the lender’s valuation may not agree and that can have serious and expensive repercussions. This is particularly crucial when bidding at auction as a mistake here can be dreadfully expensive. Do your home work, we recommend if possible invest $250 and have a professional valuation completed. It is fine to buy with your heart, just make sure your brain is connected with two feet firmly on the ground. One thing that’s worth doing is bringing along a friend to your second inspection. Try to keep them away from the hype and even from your own enthusiasm for the property and then ask them what they think the downsides are, and what their valuation is.
But remember that you only live once. If you’re buying a property to live in, and you plan to do so for a long period of time, and – of course this is crucial – you can afford it – then the rational thing to do is to bid a little above the odds if it’s necessary to secure the property. You only live once.