A sunk cost is the term that is used to refer to money that has been spent and cannot be recovered. It’s a vivid way of describing a cost for an object we can still see, but one that is not relevant to a rational decision moving forward.
In real estate, the biggest example of the sunk cost fallacy is when a property owner confuses the cost of the building they purchased, or prior renovations they undertook, and base a decision on what to do next as if those costs were still an important part of the analysis.
Let’s review a key principle in real estate and how the sunk cost fallacy plays into it.
Highest and Best Use
In any area, a search for homes for sale results in listings for properties that are effectively being sold for land value. While they may have a structure on the land, the seller recognizes that the home is either in such bad shape, or so out of keeping with the neighbourhood (such as a tiny house on a large lot where all the neighbouring properties have large, new build homes) that it should be treated as vacant land.
This follows a principle in real estate appraising called highest and best use. It’s commonly defined as:
The reasonable, probable and legal use of vacant land or an improved property, which is physically possible, appropriately supported, financially feasible, and that results in the highest value.
When we consider a typical residential property in a typical residential neighbourhood, the highest and best use is most often continuing the current usage as a residential home. The key word in that sentence is “typical”. If the home is broadly in keeping with its neighbours in terms of size, style and finishes, then the highest and best use is likely maintaining that home. Money spent on renovations or updates to such a home is a reasonable investment as the value in the building itself still exists.
If, on the other hand, the property has a home that is inferior to the typical home in the area, the highest and best use might be a tear down and building a new home or selling as vacant land. The decision as to what to do requires getting the full story.
The First Part of the Story
With such properties, a property valuation based on market research of move-in ready, typical homes is only 1/3 of the story. Such a property valuation tells us what the home would be worth if work was done to bring it up to the standard in the area.
This is useful information, but given the home isn’t typical for the area, the valuation isn’t reflective of this specific home and more information is needed to complete the story.
The Other Part of the Story
Determining the cost for such work, whether it is substantial renovation or a tear down and construction of a new build home, requires the assistance of architects and builders. Estimating such work and the carrying costs during the renovation period is a complicated task and requires experts in the appropriate fields. When that is done, we have another 1/3 of the story.
Even with the cost for the work known and the estimated value of the property once it’s up to area standards is known, we are still missing one piece of the puzzle – what is the property worth in its current state?
To determine the answer to this question, the Realtor needs to do a very different type of valuation. Land valuation involves identifying properties that have sold in an “as is” condition or even specifically listed as land value only, and breaking down the price per sf of frontage, buildable area on the lot and other considerations.
It’s complex and involves assumptions based on data but doing the work means we have an estimated value of the property in its current state. With that, we have the three pieces of information necessary to decide the highest and best use for the property.
Run the Numbers
Here’s the simple calculation we can do once we have the full story as described above.
(Estimated value of property if brought to area standard) – (Estimated value of land in current state) = (Budget for renovations to bring to area standard)
Say we have a property that is estimated to be worth $900K if it was typical for the area. The work up for the value of the property as is (effectively just the land value) is $700K. This leaves us $200K as a budget for the renovations.
Now that the budget for the renovations is known, we take the actual work up of what the work would cost and see three possible outcomes.
The budget is too small for the cost of the renovations.
The renovations to the home require substantial work, putting on an addition and major work. We’ve got $200K before it’s better to sell it just for land value. If the estimated cost for the renovation is over $200K, it’s best to sell the property for land value.
The budget is just enough for the cost of the renovations.
The work up for the cost (including carrying costs) to renovate to the area standard comes in at pretty much the budget. Selling the land as is or doing the renovations and then selling net you the same result and it’s up to you which approach you want to follow.
The budget is more than we need to do the renovations.
The amount of work required to bring the home up to area standards is not as substantial and the budget we have for it is actually more than we anticipate needing. Selling the property as land value doesn’t make sense in this case, as the highest and best use is a renovated property that is up to the area standards. Do the work and sell it as a newly renovated home.
Avoid that Sinking Feeling
If a property owner works with the right Realtor and other professionals, they can get an accurate understanding of what the numbers look like to bring a property up to the local standard.
Unfortunately, in some cases, a home owner may fall victim to the sunk cost fallacy and not even realize that the above calculation should be done. If a homeowner fails to run the numbers because they persist in thinking that the price they paid for their home is a cost that impacts whether they should do a renovation, they can end up spending money in order to get a less lucrative result.
If you have ever seen a dated home in a neighbourhood with lots of infill new builds, where the home owner decided to spend hundreds of thousands of dollars to improve their home, you will have seen the sunk cost fallacy in action. The end result can be a home that is fundamentally still not at the same standard as newer builds on the street, with an invested cost that exceeds the cost for the superior newer builds.
When the estimated value of the property once it’s up to area standards is known, the estimated cost (including carrying costs) for the renovations and the value of the property in its current state, the decision as to what to do can be made.
We’ve been focused on a property that is already owned and what makes the most sense, but the same three pieces of information will allow a buyer to decide what price they are willing to pay for a property that is below the area standard. If the cost of the property, plus the cost to do the renovations, is more than the cost of properties that already at the area standard, then the buyer will be better off buying a property that is typical for the area. Avoid the stress of the renovation, get a finished product and don’t risk market shifts while you undertake the renovation.
If you want to make sure you don’t fall prey to the sunk cost fallacy, then we’d be happy to help make sure the numbers are done correctly, and the right decision is made. Get in touch with us to get the ball rolling!