Picture this scenario: a couple decides to sell their property as their children have now grown up and moved out. The property was originally quite run down and the couple worked hard to upgrade it significantly through numerous alterations and landscaping.
Having approached an estate agent they are shocked to hear the proposed valuation as they expected a far higher price. They subsequently either choose not to sell or insist that the property be placed on the market at an unrealistic price. After all, they put so much effort into the property; it must be worth more they argue. The property remains untouched on the market for over a year until they finally drop the price in a bid to sell.
Many an estate agent and homeowner reading this will be able to relate. It’s a common scenario both locally and abroad. This seemingly unreasonable behaviour could be attributed to a theory known as the ‘endowment effect’ which was first put forward by the eminent behavioural finance theorist and American Economist Richard Thaler in 1980. The theory works according to the premise that people value goods more once their right to it has been secured through payment. In other words, people place a higher value on the objects they own than objects they do not.
Although relatively unknown, the endowment effect has far reaching consequences for sellers in the property market and could strongly affect their judgement in terms of value and pricing. An alternative definition of the endowment effect is ‘divestiture aversion’ which states that people are unwilling to let go of what they own unless the selling price makes the disposition worthwhile.
Divestiture aversion can be viewed positively in that it restrains sellers from letting go of a property too quickly when the initial price offer is too low. This principle holds true even in difficult property market times.
Everyone is affected by these two principles to a greater or lesser degree. That said, when it comes to selling property, recognising the endowment effect for what it is and the impact it could ultimately have on your long term investment goals is crucial; especially against the backdrop of a recovering property market.
Unpacking the endowment effect
The endowment effect is a cocktail of interlinked elements which, when combined, can steer investors off-course. Emotional bias is a key element of the endowment effect. It is human nature to become emotionally attached to a property, especially if a person has worked hard to buy and refurbish it; has occupied the property for a number of years and/ or harbours fond memories of their time spent there.
Further to the emotional bias aspect is the fact that people view possessions and property as extensions or reflections of themselves. They feel that they are selling off a part of themselves; a thought process which clouds judgement in terms of price expectations. It could be argued that other emotional aspects such as fear of change and yes, greed, also play their part in relation to fuelling the endowment effect.
Other, non-emotional aspects such as over-priced property valuations stemming from estate agents seeking sole mandates, insurance values and municipal values can further confuse a seller in terms of price expectations. Insurance values are, as a rule, higher than market related values because they are formulated according to the replacement value of the property, i.e. the amount required if the property was destroyed or damaged.
Municipal values should reflect a property’s market related value. General municipal valuations are compiled according to a systematic process of valuing many properties at a given date using statistical procedures based on property sales and market conditions. A physical inspection of each individual property is not compulsory.
Unfortunately, there have been instances where municipal valuations have been incorrect and misled sellers. Those looking to sell should have a comparative market analysis performed citing the sale prices achieved by similar homes in the area to ensure the correct values are attached.
Ultimately, to avoid confusion, sellers should focus on a property’s market value. A property’s market value is linked to factors such as the state of the economy and demand for property in an area. As such, these valuations will generally be lower than the insurance value but provide realistic price parameters.
The ‘endowment effect’ in today’s market
It could be argued that the endowment effect spiked somewhat at the beginning of South Africa’s property market downturn when many homeowners came under financial pressure and were forced to sell their primary or investment properties. Nobody likes being forced to sell anything, especially when it comes to what probably equates to a person’s single biggest asset and source of present and future wealth.
Motivated by panic, greed and financial over-commitment, property owners rushed to sell and ‘cash in’. Properties were marketed at prices sellers wanted, needed or expected: in other words, unrealistically. It was a scenario that was further compounded by the endowment effect.
Unsurprisingly these properties languished on the property market for far longer than their realistically priced counterparts did or simply didn’t sell at all. There are lessons to be learned from such events. Overly-strong markets that absorb unrealistically priced properties tend to be unsustainable, unpredictable and fuel the endowment effect. A softer property market that encourages realistically priced properties is sustainable over the long term and mitigates the endowment effect.
At present, the percentage of South African properties which are currently selling at below asking price has declined. The average time a property spends on the market has also decreased. These two indicators, when read together, point towards more realistic pricing by sellers.
This greater realism may not only be due to sellers setting prices lower but could be attributed to the market catching up to price levels, therefore making previously unrealistic price levels now a little more realistic.
Be on your guard
Given human nature, the endowment effect has always and will always have an impact on the selling process to a greater or lesser degree. Over-priced properties will also always be a factor, whatever the market. Fortunately the present property market should, to a large extent, underpin realistic price parameters.
To avoid endowment effect pitfalls, seek the advice of property experts such as estate agents and registered property valuers. Conduct thorough research and obtain valuations from at least three estate agents which will give you a fairly good idea of what kind of price you could expect. Estate agents who have a good reputation and who are most active in your area will usually be able to give you a true indication of the value of your property.
Avoid adding too many unjustified alterations and features to your home. While it might appeal to your tastes, you might actually be making it that much harder to sell to the majority of buyers. By the same token, be careful not to over-capitalise on a property in an area that doesn’t warrant it.
In a nutshell, recognise the risks of the endowment effect; disregard sentiment come sale time and consider the long-term implications of certain additions and alterations, failing which you might end up selling your home for far less than you put into it or end up holding out until you find buyers who share your preferences.