The real estate math mistake we all make

Selling a paid-off home is pure profit, but our brains just don’t see it that way

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Most financial choices boil down to simple math. Add up the gains, subtract the costs, and you should get a number that helps you draw a conclusion. Those numbers are particularly useful when trying to make a major life decision, such as whether or not to sell the family home.

Given how hot big city markets like Toronto are these days, the math would certainly make a compelling case to sell. Yet according to the April sales data from the Toronto Real Estate Board, listings are down 27% year-over-year in the GTA. Despite brisk sales and skyrocketing prices, most homeowners living in semi-detached and detached homes are choosing to stay put. (A similar lack of inventory is plaguing Vancouver, Halifax, Ottawa and nearly every large city in Canada.)

TREB’s rationale for the dearth of listings? A widespread aversion to the high cost of land transfer. Other people have surmised that the scarcity is a symptom of our fear of paying a premium on the next property. After all, while you may sell high, you’re also forced to buy high—a proposition that leaves some feeling like prisoners to the status quo. But I think there’s another reason people aren’t selling as many homes these days, and it’s buried deep inside our brains. More precisely it has to do with how we process gains and losses.

According to Nobel-prize winning professor Daniel Kahneman, we’re hardwired to overvalue a loss and undervalue a gain. “The aggravation that one experiences in losing a sum of money appears to be greater than the pleasure associated with gaining the same amount,” is how he puts it.

To appreciate what Kahneman means, consider the case of Larry and Laura. Retired for three years, the Toronto couple have a comfortable debt-free life, funded by modest pensions, savings and government income programs. Thing is, they could have more money in the bank if they sold their home—let’s say they bought it 15 years ago for $250,000. But Larry and Laura can’t wrap their heads around selling and downsizing in such a crazy market, even though they could probably sell it for $750,000 or more.

The math says they’d be ahead by as much as half a million. But that calculation isn’t entirely accurate, at least not from an economist’s point of view. To understand how they’re undervaluing their gains, you have to consider the difference between sunk costs and opportunity costs. Sunk costs are anything spent that cannot be recovered. For Larry and Laura, that would mean the money they paid into the mortgage, the time and money it took to maintain their home and the emotional and mental energy they invested in raising a family in the house.

The opportunity cost, on the other hand, is what’s incurred from not taking the next best alternative. This is a fancy way of referring to all the ways Larry and Laura could be spending their time and money if it weren’t tied up in their family home.

Pretty straightforward, right? Only Larry and Laura aren’t as rational as they think. The idea of dismissing all the money, time and energy they poured into their family home feels like the emotional equivalent of losing their investment, a perceived loss that prompts them to overvalue their sunk costs. Economists would say this is irrational. They would explain our refusal to dismiss these irretrievable expenses as a “behavioural error” or an action that doesn’t conform to rational choice theory (a principle that assumes we always make the prudent and logical decision that provides us with the greatest benefit).

If Larry and Laura were truly rational, their real gain for selling their debt-free family home would be closer to $750,000 (the sale price minus transactional costs). Even if they chose to repurchase in the same market, it would likely be something smaller and less expensive; they’d still have money left in the bank to spend on travel, explore new hobbies or give to their kids and grandkids. So does that mean Larry and Laura should sell? Yeah, maybe. Since each person values a future gain slightly differently, it’s important to ask yourself the following questions:

1. What are the intangible and tangible sunk costs so far?

2. Am I willing to accept that these sunk costs will never be returned to me?

3. If so, can I see what I may be missing if I overweight costs that are irretrievable?

4. Finally, what would I actually gain if I were to sell and move now?

It’s totally understandable if you answer these questions and still choose to pass up the opportunity for a large financial gain. Sometimes the math used to determine a home’s value ignores the intangibles—factors that can outweigh even the most compelling balance sheet surplus. But going through an exercise like this will help anyone make a more informed, more rational decision. It’s better than feeling trapped in the status quo, a prisoner in a surprisingly expensive home.


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2 comments on “The real estate math mistake we all make

  1. The headline suggests that selling a paid-off home gives a “pure profit” and the text goes on to explain that this profit is equal to the sale price less transactions costs. When assets are bought then sold profit is usually thought of as the capital gain that has been made on the investment. This is what is taxed where capital gains are taxable. Family A that bought a house worth $750,000 today for $250,000 15 years ago has made a capital gain of $500,000. Ignoring costs such as maintenance and mortgage payments, family A has earned an annual rate of return of about 7.6%. If family B bought an identical house for $350,000 a year later (14 years ago) which is also worth $750,000 today most would agree their capital gain is $400,000 and their rate of return over 14 years is about 5.6%. To suggest that if both families sell for $750,000 then both have gained a “pure profit” of $750,000 (less transactions costs) does not seem in line with any reasonable definition of profit.
    When assets are sold net wealth does not change (apart from a decline equal to transactions costs) Wealth has simply been rearranged – less housing wealth, more cash for example) of course capital gains/losses will be “realized” and there may be tax implications. A decision to swap one asset for another often depends on what the investor believes will yield the higher (risk-adjusted) return in the future. Selling a house can be more a complicated investment decision because we have to live somewhere and we all have locational preferences.
    Finally, the land transfer tax on a $750,000 property amounts to about 1.5% of the sale value. If TREB thinks this is a significant factor in limiting supply perhaps TREB should encourage competition to bring real estate commissions down from 5% to a rate consistent with fees in other countries such as the USA and the UK since at the moment fees are more then 3 times the land transfer tax.


  2. We ( nearly) all make OK? Not to mention capital appreciation is tax free! Thank you


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