The Real Cost Of Not Selling An 'Underwater' House


As is probably true with all financial planners, I’ve had countless discussions with clients who refuse to sell an asset they no longer want, until they can recover their original purchase price.  Often these conversations revolved around stocks, but increasingly, we are hearing this same viewpoint about houses as well: “I bought my house for $1,000,000; I’m not willing to take a loss.”

Perhaps it’s a bit easier to understand this reluctance to listen to the marketplace when selling a home, rather than securities, as there may be a visceral attachment to a residence where, say, one’s children were raised (although, corporate executives can be equally attached to their company’s shares).  There also might be some truth to the point of view that the local marketplace for houses is less efficient than the national exchanges are with stocks (“with a house, it only takes the right buyer”).

That said, I believe the best explanation for holding out for a higher price than the marketplace is willing to pay is the cognitive bias know as the “Endowment Effect.” Cognitive biases often have us act differently than economists would predict.

In 1980, the recent Nobel laureate Richard Thaler coined the term “Endowment Effect” noting “people often demand much more to give up an object than they would be willing to pay to acquire it.”  But is a house of greater value simply because we own it?  The endowment effect is the psychological bias that would have us believe the answer is “yes.”  Unfortunately, the seller’s perspective may not be shared with the universe of potential buyers.  The literature of psychology and behavioral finance has many studies concluding, essentially, that we overvalue that which is already owned.

As with most economic matters, deviating from the marketplace of supply and demand carries a price – for example, if you’re holding a house that is listed for $1,000,000 that would quickly sell for $800,000.  Simplistically, say that the annual carrying cost (real estate taxes, insurance, maintenance, etc.) is $35,000.  Add in the opportunity cost tied up in the house (say, 5% of $800,000) is another $40,000.  The real cost of mispricing the house would be $75,000 annually. This does not include the risks associated with carrying the house, including the hassles of working with agents and prospective buyers and the ever-present risk of a further decline in real estate values.

Cognitive biases are powerful deterrents from one’s best economic interests.  When pricing any asset, it often makes sense to consult with objective third parties on pricing, and ask yourself if your Endowment Effect bias is clouding your judgment.

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