The Endowment Effect is a term coined by economist Richard Thaler in 1980 to describe the gap between a person’s Willingness to Pay (WTP) and Willingness to Accept (WTA). In simpler terms, the owner of an item perceives its value to be higher than a potential buyer does. It is similar to the “my baby is the most beautiful” syndrome.
I read two different theories about this. The one that truly spoke to me was written by Per Bylund and published by the Ludwig von Mises Institute in December of 2011. The article explores how economists have battled with this effect, due to modern economics’ placing higher value on mathematical explanations than psychological ones. However, the psychology behind the Endowment Effect does make a lot of sense.
How the Endowment Effect works
When purchasing something, a buyer needs to believe he/she is getting a deal. Otherwise, there is no gain and, therefore, no motivation to make the trade. For instance, in the case of real estate, potential buyers need to feel like they are getting a lot for their money. So, if they perceive a home’s value to be $500,000, they will want to pay less than $500,000 so that they gain from trading their money for it. Therefore, they might willingly pay $480,000 for the home. However, when they go to sell it, they want to price the home at their original perceived value of $500,000 or more — this doesn’t include any improvements they have made to the home, the emotional ties they may have created during ownership or the potential added value they place on the risk of losing it.
There is a twist: if someone is selling a home, but is not yet actively seeking a new home, they are not measuring their current home’s value against others. They are only seeing the benefits of their home. Conversely, most buyers currently have a home against which they will measure any potential new home. They will see both the drawbacks and the benefits of the new home.
Then there is another twist: a product’s perceived value is different when it has a current use as opposed to a potential use. A simple example of this is that a tennis racket is more valuable to someone who plays tennis than someone who does not. Why? The tennis player has use for that racket while the non-player does not. A home’s features increase its value for the seller, who is probably using all of them. But it does not increase the value for the buyer, who has yet to begin to use them.
Wow. We now have one incredibly lopsided playing field for valuation. The Willingness to Pay does not meet the Willingness to Accept.
So, how do we use this knowledge in helping a homeowner price a home at market value?
The three steps to helping a homeowner price a home are 1. Education. 2. Education. 3. Education. We need to create a value adjustment in their minds by reorienting them in the current market reality and bringing them closer to their goals.
- Help them understand recent market pricing. Show them details (including photographs) of comparable homes that have recently sold. If possible, schedule a tour of a few of these homes. Help them establish monetary value on the differences between each of those homes. Showing only alphanumeric statistics is not enough to help them establish value on the sold homes. Seeing photos and understanding their locations is much more effective.
- Show them their current competition. Whenever possible, invite them to tour the inside of homes that are currently on the market, as well. Make sure they understand that established sold prices should be given more weight than current asking prices. Placing them in the “buyer’s” frame of mind will create a more even playing field for pricing.
- Help them place value on moving. Find out what their goal is and if they are currently looking for their next home. You might say, “Well, obviously their goal is to sell their house!” Well, that is only part of the story and not finding out more puts you at a disadvantage. Here’s an example: Let’s say the sellers are an older couple who are concerned about climbing the stairs of their two-story-plus-basement home everyday. They are tired of mowing the lawn, weeding, raking and shoveling. They like to go to dinner and a show, but their current home is a 30 minute drive from the city and neither of them likes to drive at night anymore. Their goal is not just to sell their house. Their goal is to move into a single level condo in a low-maintenance building in a culturally active part of town. But, if they have not begun looking for a new home, they aren’t comparing the value of what they will gain to what they are giving up — they only see what they are giving up and that is hard. So, sign them up for MLS updates to view homes that fit the criteria of their goals. This will allow them to begin to see themselves in that next phase of life and build value in that. It might help them start to break the emotional attachment to their current home. It also may increase their motivation to sell.
These steps begin to level the playing field for valuation. Now, we want to help the potential buyers feel some of what our current homeowners feel.
How do we use the Endowment Effect in marketing homes?
We know that a potential buyer needs to be able to see the value behind the pricing. They need to be able to feel they are gaining from the exchange of their money. So, let’s help them do that…
- Stage the home so it looks its best. Be sure that there aren’t maintenance issues that will automatically reduce the value in the eyes of the buyer. Be sure you understand all the benefits of living there by interviewing the current owners and crafting the written message accordingly. Then, take as many photos as possible. If you have a good videographer, make a video. We want them to feel enticed by the language, photos and videos they see online.
- Make sure the house is clean and ready for showings at all times. If there are pets, be sure they will not be present during showings. Ask homeowners not to cook pungent foods during this time. We want buyers to feel comfortable when they view the home. They should be able to imagine themselves living there.
- Be present as the seller’s agent at all showings. You will need to communicate the benefits of the home and handle any objections that arise. You should also find out the goals of the potential buyers to see if you can find synergies between their goals and owning the house.
- Get quality marketing materials that reflect the value of the home. Don’t just print out MLS sheets. We want the take-away materials to remind them of what they saw and support the value you have placed on the home. If you found those synergies, physically point them out to the buyers during the appointment in the brochure so that they are reminded of the benefits after they leave.
How do we use the effect in negotiations?
Once you have priced the home, put it on the market and done your marketing well, you should begin getting offers. But, your homeowners may still be struggling with the value gap. If they still haven’t reconciled their ideals with the home’s true market value, you will need to help them reorient themselves in the current reality. It is important to help them remember what their current home ISN’T doing for them and what their next home WILL do. This brings their perceived value of their current home closer to the buyer’s offer. You might say, “Well, the offer isn’t what you dreamed, but it IS close to what our market analysis told us. So, the question is, does this allow you to achieve your goals? And what do we stand to lose or gain by waiting for another offer?”
Ultimately, the decision to sell belongs to the seller. But, we can create better circumstances for them to find success. If you understand the Endowment Effect, you can reduce the inequities in perceived value and help your clients achieve their goals, without undermining themselves.