Mike Kueber's Blog

May 17, 2014

Sunk costs

Filed under: Business — Mike Kueber @ 1:00 pm
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Earlier this week, one of my sons told me that the renters in his rental house said they loved the house so much that, instead of extending the lease another twelve months, they would like to buy the property.   My son rejected that possibility out-of-hand, not only because the rental activity has been profitable, but also because he is interested in expanding his inventory of rental properties.

During our conversation, my son mentioned that one of his considerations against selling the house was that he had recently gone through the expensive process of refinancing the house to secure a more favorable interest rate.  That consideration initially made sense, but upon further reflection, I concluded that it did not, and I sent him the following email to point this out:

  • During our conversation about your rental house, we lapsed into flawed thinking that I didn’t realize until I was on a bike ride later in the day. Although the flawed thinking doesn’t necessarily change your decision to rent your SA house instead of selling it, it is something that we should keep in mind.
  • The flaw – We both agreed that there is a general guideline that refinancing is not a smart decision unless you can lower your interest rate by a couple of percentage points and that you don’t sell the house for about five years. Based on that guideline, we concluded that it made sense to keep renting your house for at least another four years to offset the cost of the refinancing. Upon further reflection, I believe that thinking is wrong. Actually, the costs of refinancing are so-called sunk costs, and, although they made economic sense based on your expectations at the time you spent them, they should not play any role in future decisions on selling vs. renting. An analogy would be me making decisions on the fate of Jimmy’s pickup based on the money that I have spent recently fixing it up. I shouldn’t decide to keep it just because I want to get my money’s worth for tuning up the engine or fixing the suspension or repairing the A/C. Similarly, deciding whether to sell a stock shouldn’t depend on whether I would be selling at a profit or a loss; instead, I should sell the stock whenever I think it is overpriced and is going to drop.
  • So, deciding to rent your SA house probably makes economic sense to you for a variety of reasons, but one of them shouldn’t be the money you have already spent on refinancing the house 12 months ago. You are renting the house because it provides you a monthly cash flow and along with an increasing equity interest. The only reasons to sell would be to eliminate the business risk, which we believe is not great, or if the offered price was too generous to turn down.”

My son didn’t necessarily agree:

  • “Good point but I think you are still looking at it a little off. You compared the house to Jimmy’s truck but that is not quite a good comparison since Jimmy’s truck is a complete liability in that it only will decrease in value and does not generate any income. My house is an asset that generates income in part due to the money that I invested to refinance it. A better comparison would be to compare it to a rental car. The rental company would not want to sell its rental cars until at least the cash it had generated and its sale price were greater than the money that the company paid to purchase and maintain the car. You could keep Jimmy’s truck forever and it would never make back the money you spent to tune it up.”

I didn’t agree and responded as follows:

  • “Maybe Jimmy’s truck isn’t a good analogy, but the point is that it is sometimes a mistake to make decisions to stay with a course of action just because it will prevent a previous decision from looking bad. For that reason, perhaps the stock analogy is the best one.”

Upon further reflection, I think my position could be better defended with the following undeniable fundamentals:

  1. Every asset that you own has a price, especially investment assets.
  2. Your selling price for an asset, especially an investment asset, depends on considerations such as its current market value, its likely future market value, its value to you, your need for cash, your alternative investment opportunities, and a property’s cash flow. But the amount that you paid for an asset should have, logically, almost no effect on your selling price for that asset.

I realize that these fundamentals essentially beg the question, but thinking in terms of establishing an asset’s price makes it easier for the evaluator to see the irrelevance of an asset’s prior costs or expenses – i.e. sunk costs.  Wikipedia provides a better explanation of sunk costs:

  • In traditional microeconomic theory, only prospective (future) costs are relevant to an investment decision. Traditional economics proposes that economic actors should not let sunk costs influence their decisions. Doing so would not be rationally assessing a decision exclusively on its own merits.
  • Evidence from behavioral economics suggests this theory fails to predict real-world behavior. Sunk costs do, in fact, influence actors’ decisions because humans are prone to loss aversion and framing effects. In light of such cognitive quirks, it is unsurprising that people frequently fail to behave in ways that economists deem “rational”.

About.com says essentially the same thing:

  • Sunk costs are unrecoverable past expenditures. These should not normally be taken into account when determining whether to continue a project or abandon it, because they cannot be recovered either way. It is a common instinct to count them, however.

Thus, the cost of securing a favorable mortgage is already sunk and should have no effect in a deciding how much money would be enough to entice my son to sell his rental house instead of continuing to rent it.  But loss aversion explains why it does.

 

 

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