The concepts of 'pride of ownership' and 'sweat equity' complicated the American Dream of home ownership for many.
Last month, we talked about how the pride of ownership can lead our clients to overvalue their own preconceived notions about financial planning and investment management. We uncovered a couple of common financial decision points where marketing professionals have successfully used the pride of ownership against our clients for decades. Manipulations of the human pride of ownership have been at the center of many marketing campaigns for consumer products, but it doesn't stop there. This month, we are concentrating on how these concepts played out with respect to home ownership and the recent housing crisis.
The American Dream
The American Dream of home ownership was at the center of economic policy in the last decade, as relaxed lending standards made it possible for a larger and larger portion of the American population to "afford" a home of their own. Whether you believe our housing crisis was perpetrated by fraud and rampant corruption, savvy business people, or flawed financial decision-making by families, the pride of ownership concept was used on Americans in a way we have never seen before.
The machine of mortgage brokers, homebuilders, loan originators, realtors, big banks, economic policy, and investors created a system that allowed everyone the opportunity to feel the pride of ownership. The exuberance was most definitely economically irrational. No economically rational decision-maker would have taken on mortgages they couldn't afford to pay. No economically rational mortgage lender would have loaned money to a family who couldn't prove its income even existed. No economically rational investor would have invested in real estate on the premise that values only go up.
What really happened was that the system, intentionally or not, created a scenario where nearly everyone could feel the pride of ownership. Given the opportunity, almost everyone would jump at the chance to own a home and to make it their own.
The interesting complication in this situation was that people did not need to already own a home in order to make irrational decisions about its economic value. Instead they made the bad decisions in order to attain the pride of ownership. The American Dream they've strived for was now attainable, and who were they to look a gift horse in the mouth?
We think the crisis was spurred on by a little bit of irrational crowd behavior. People lined up at model home sites and waited in line for their chance to own a piece of the American Dream. Bidding wars created sellers' markets where buyers routinely paid more than the asking price for a home. Just think. Would you ever walk into a grocery store and willingly pay over asking price for a loaf of bread? Probably not. So there must have been an emotional component behind the economically irrational bidding wars that became common in the 2000s. The pride of ownership may have been the catalyst.
The irrational behavior didn't necessarily end after the home was purchased. Think also about the home improvement labor exerted by a homeowner and the perceived value of that labor on their real estate. We hear the term "sweat equity" often from clients. They are referring to the value they associate with a home based solely upon the work they have put into creating it.
Most of us will break a sweat in the garden or painting a bedroom. But just because you broke a sweat doesn't mean you created any value. In fact, many home renovation experts will tell you to expect only a 60% to 70% return of your investment from home renovations.
In reality, the labor our clients have contributed to the creation of a home can have a major effect on the value they associate with it. The problem is that "sweat equity" often has nothing to do with economic equity.
In our divorce practices, we sometimes refer to the marital home as the "marriage museum," filled with memories of family, good times, holiday dinners, and changing dirty diapers. It is a natural human function to place a value, consciously or not, on the hard work that went into renovating and decorating a home and filling it with a loving and healthy family.
The world might be a better place if parents were rewarded financially for being loving, caring, and nurturing mothers, fathers and homemakers. But you cannot sell your memories, your sweat equity, or your family with a house when it comes time to move on.As you can see, we are inclined to be very emotional about our homes, but in addition to being the place where the heart is, our homes are also major economic assets. In order to make the best possible decisions about which home to buy (or even whether to buy at all), how much to invest in renovations, and how much a property is actually worth, we must also see the true economic picture. Speaking to our clients in purely economic terms like "pride of ownership" will often be unsuccessful. Try instead to make comparisons like those in this article to help clients realize how often economics and psychology intersect. The realization alone will help them think more "rationally" over time.
Next month we will begin a more detailed look at the psychological underpinnings of behavioral economics. We will take a further look into the psychology of crowd behavior, "keeping up with the Joneses," and the fallout of economic irrationality that plagued the last decade in our country. Over the months, we will look deeply into how the crisis has and will continue to affect your clients and what we can do to help them make more economically rational financial decisions.
Justin A. Reckers, CFP®, CDFA™, AIF® is Director of Financial Planning at Pacific Wealth Management® and Managing Director of Pacific Divorce Management, LLC based in San Diego, CA. www.pacwealth.com, www.pacdivorce.com
Robert A. Simon, Ph.D. is a forensic psychologist, trial consultant, expert witness and alternative dispute resolution specialist based in Del Mar, CA.