Frederick Peters Contributor
In my experience, even the smartest sellers become overly concerned with the price for which they sell their property when planning to purchase another. What psychologists call the “Endowment Effect” takes hold: that is the psychological process by which we tend to overvalue what we own (because we own it), while tending to undervalue the possessions of another. Thus sellers tend to hang on to the idea of the specialness of their own property; they can feel disappointed even when receiving a strong offer, if it doesn’t line up with what are often their unrealistic expectations regarding the value of their property. This endowment effect works most strongly against sellers when they wish to trade up to a more expensive property.
Everyone loves being able to say “I bought it for $1 million and sold it for $2 million six years later.” What this equation doesn’t include is the acknowledgment that, in the red hot market which made that appreciation possible, the larger place this seller has just bought cost $3.5 million, so he invested another $1.5 million to trade up. While it’s less impressive to say “I bought it for $1 million and sold it for $1.2 million six years later,” the benefit is that in a market which has only appreciated 20% rather than 100%, that larger place only costs around $2.1 million. So in real dollars this seller’s “disappointing” profit on the sale actually translates into a saving of $600,000 on the sale and the purchase taken together.
Why does this work? In a market which has delivered 100% returns, the rising tide floats all boats. That new property for which our seller pays $3.5 million would have been worth $1.75 million six years earlier, when he bought his original home for $1 million. Therefore, just as the seller’s current apartment has doubled in value from $1 million to $2 million, the bigger apartment has doubled in value from $1.75 million to $3.5 million. But if the market rises much less briskly, or even goes down, the difference in actual dollars between the smaller property the seller disposes of and the new larger property she acquires shrinks. Thus in the example above, if the original property has only increased 20% in value to $1.2 million from its original price of $1 million, the new property, subject to the same market forces, would only have increased the same 20%, from $1.75M to $2.1 million. So the trade up costs her $900,000 ($2.1 million minus $1.2 million) rather than the $1.5 million described in the first example above, in which the value of both properties had risen 100%.
Of course, any number of other variables play a part in determining value. But this fundamental rule holds true: it’s always better to scale up in a bad market and to scale down in a good one (for reasons which are exactly the opposite of those described here.) For anyone selling and then buying at more or less the same time, absolute value matters far less than relative value, the difference between the price the client sells for and the price she buys for. The huge price a seller gets for her property may give her bragging rights, but it almost guarantees that she will pay a huge price for her new place. To me, fewer bragging rights and more money left in the bank seems more like a winning formula.