Home Prices – Value Gap

Sometime back I wrote about why homeowners list their prices at higher prices than the comparable sales prices in their localized market.  I theorized it is due to endowment effect and ignoring opportunity costs. It appears now the list prices are starting to reflect the market rather than what the homeowners value. Here is a report on MarketPlace:

Chris Mayer tracks real estate at Columbia’s business school. He says reality is finally sinking in for home sellers.

CHRIS MAYER: There’s an initial loss and people are looking at this and saying, but God, I paid $400,000 for the house. I’m just not going to sell it at $300,000. And over time, people realize that $400,000 isn’t coming back and they adjust their expectations.

According to the report. quarter of all homes that are for sale have dropped in prices at least once.   Behavioral economists say, homeowners are going to feel pain every time  they drop prices that is comparable in magnitude to the pain felt with the first price drop.

What does it mean for those who have their house on the market? Emotionally,  it is better for them to calculate more accurately the required price drop and do it once rather than do it in steps.

Business Built On Endowment Effect

Endowment Effect,  introduced by Thaler, states that people tend to value things they own more than they are valued by the market. Hence people are reluctant to let go of things they own at the market price and end up accumulating them. The New York Times magazine profiles  the business that is build on this, Self-storage. People are not rational automatons, they are not aware of sunk costs nor are they capable of doing net present value calculations of multiple options. They cannot tell the monetary difference between storing their wares in self-storage vs. selling them now in garage sales at the prices the market is willing to pay.

Clem Tang, a spokesman for Public Storage, explains: “You say, ‘I paid $1,000 for this table a couple of years ago. I’m not getting rid of it, or selling it for 10 bucks at a garage sale. That’s like throwing away $1,000.’ ”

People end up paying $100-$200 per month for storing things that will not even cover the rent if they were to be sold off. The result is a thriving business – self-storage  that adds negative value to most of its customers. The question is will we see a return to rationality due to current economic conditions?

Other related articles:

  1. Endowment Affect in Wendy’s commercial
  2. Theory Behind Home Staging
  3. Pricing Garage Sale

Slow decline of Home Prices

Shiller (of Case -Shiller index) wrote in The New York Times about why home prices fall slowly instead of crashing and why the prices may continue to fall. This is a great explanation of the averages and the reasons for slow decline. Two questions occur to me:

  1. Why does a homeowner start with a very high list price even though the market price (based on comparable homes) is lower?
  2. Why are homeowners willing to let go an offer only to settle later for the same or lower price?

The reason for the high list price can be attributed to endowment effect. People tend to value things they own more than the things they do not. This is nicely demonstrated in a video by Dan Ariely. There is considerable emotional connections that get translated into higher utility and hence a higher valuation. In addition to this people do not consider opportunity cost of carrying the home for longer time. This results in initial high priced listing despite the fact that comparable houses in the neighborhood have been in the market for a much longer time and are currently priced lower than this house. Unfortunately buyers do not share the same emotional value hence houses end up sitting in the market longer.

The reason for rejecting reasonable offers during the initial days only to settle for same or lower price later is due to mental accounting that ignores the opportunity cost of carrying the home longer. Opportunity cost here includes additional mortgage payments, carrying costs and most importantly lost revenue from capital tied up in the house. Even if they considered opportunity costs, homeowners overestimate the chances of getting better offer and underestimate the time they need to wait for such an offer. Due to  high initial price, a low offer will also look substantially lower.

The net result is prices not reflecting what the market is willing to pay. Hence the slow decline of home prices.

Theory Behind Home Staging

In the down economy and slow housing market, most homeowners are staging their house for the sale. To a homeowner the value from staging comes from

  1. Higher price than they would have received otherwise
  2. Shorter time on the market and hence savings on carrying costs

Does staging work? Does it improve sale prices and days on market? What could be the consumer behavior theories behind it?

I hypothesize that there are reasons to  believe that staging works. Sometime back I wrote a piece titled “You touch it! You own it!“.  That article was based on new consumer behavior research that found that touching products increased customer willingness to pay for them. This was because touching increased ownership and as endowment effect theory show, we value things we own more than twhat the market is willing to pay for it.

The hypothesis for why Home Staging works is the reverse of this ownership effect. If we think someone else owns it then we tend to value it lower than if we owned it. A staged home reduces the footprint of the  owner and helps the potential buyer better imagine this as their own and hence helps to increase their willingness to pay for the home.

There is one statistic I saw from StagedHomes website that states, higher sale price and fewer days on the market for staged homes. This is not based on a controlled experiment but based on a survey they did. I cannot rely on these numbers to validate my hypothesis.

To test my hypothesis I should conduct a controlled experiment (controlled for time, location, listing price, size etc), randomly assign houses to be staged or not staged and measure the average sale price and mean time spent in the market for the two groups. Only if the  difference between the means of the two groups are statistically significant  can I claim that staging played a role.

I do not have the wherewithal to do this experiment so if you are considering whether or not to stage your house for sale consider writing a conditional contract with your stager. If they truly believe staging increases your home price and reduced days on market then they should agree to a structured incentive scheme that goes down in value every time you decrease your listing price and more days the house spends in the market.

Pricing Your Garage Sale – 4 Things to consider

I received somewhat surprisingly high number of views on  How to price your garage sale article I wrote. I think people are searching online because of the time of the year for tips on pricing their garage sale. The article I wrote was probably not suited for the most common garage sales that sells many items for less than $5.   Here is a set of 4 things to consider before your sale:

  1. Is it worth it?: Think of the opportunity cost of time spent categorizing, labeling, advertising and finally spending 3-4 hours manning the shop. Suppose your time is worth $50/hour, would you make more than $250 from your garage sale? If not, is it worth doing? Frugal families blog says, “anything under $2 sells fast”. That means you need 125 such items just to break even (after the opportunity cost). Note that you value your junk, err treasures, more than your potential buyers would due to endowment effect.  Don’t overestimate the total sales to justify the effort.
  2. Alternatives?: Are there alternatives to garage sale like giving the items away to local charity and claiming tax deduction? If you do not itemize your taxes this does not help you. But think of the time saved and the general euphoria, however fleeting, from donating things?
  3. It is sunk, now keep moving: You might have bought your item at a higher price or you might have spent considerable effort building or improving it. Do the money and time spent in the past justify additional time and money for holding a garage sale? No, what you spent in the past is sunk. You should only consider the effort not spent and pick the best among the alternatives.
  4. Doing it for the experience: May be you do value the experience more: If you really think that the experience of holding a garage sale means something to you, be it a lesson in negotiation or just a way to meet the neighbors then by all means do it. However see (2) again.

Endowment Effect – When a bird in hand is more than two in the tree

Here is an Ad for Wendy’s double stack burger that shows very neatly Endowment Effect. (wait for 7 seconds into the video for the Wendy’s Ad, as the beginning of the video has another Ad for Religulous)

The Adman says, “your burger has increased in value”. This is only partly true as the value is in the minds of the customer who is holding it and it is the perceived value. Endowment Effect is a theory introduced by Thaler  (of Nudge) and it states that people who own things  tend to value these more than others. Since their perceived value goes up, they are less reluctant to part with the goods at prices they bought or at the current market price.

This is the same reason home prices are not falling as fast as economic  theories suggest – people own their homes more than the market is willing to pay.

As a corollary, if the customer feels ownership of the object then their   willingness to pay goes up as well. An example of this was discussed in my last post  You touch it! You own it!