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Proposition 13 and the Endowment EffectSubmitted by Clarity Capital Advisors | Fee Only, Fiduciary Advisors on July 18th, 2018
In behavioral finance, the endowment effect refers to the observed tendency of people to assign a higher value to an asset merely because they own it. On a small scale, it is easily demonstrated by giving one group of people an object such as a coffee mug and then later offering to buy it from them at a fair price while giving another group (the control group) a simple choice of taking the coffee mug or cash. On a larger scale, you can see it by asking a business owner what he thinks his business is worth compared to his competitor’s business. You will quickly see that we live in a Lake Wobegon world where everybody owns an above-average business.
Quite often, there are legitimate reasons for different investors to assign different values to the same asset. For example, a taxable bond is a more attractive investment to a non-taxable investor compared to an investor in a high tax bracket. Similar to the idea that real estate should sell for the price that corresponds to its highest and best use, the market price of a financial asset will be set by the group that obtains the most value from it. We say group because it would be extremely unusual for a stock or bond to provide after-tax cash flows unique to a single owner. With California residential real estate, however, thanks to Proposition 13, we now have a situation where owners of equivalent homes pay hugely different property taxes and thus assign vastly different values to their properties.
Proposition 13, passed in 1978, rolled back property taxes to their 1976 level and capped annual increases at 2%, with re-assessments occurring only when properties are sold. Since California residential property has inflated at a rate far higher than 2%, this has led to a situation where longtime homeowners (or their heirs) pay far, far less in taxes than recent homebuyers. For example, a property that sold for $50,000 in 1976 and remained in the same family would have annual property taxes of about $1,150 compared to $7,000 for a similar property that recently sold for $700,000. People who are using the home as their primary residence get almost $6,000 more in discretionary income than their newly arrived neighbors, and homeowners renting out their property receive a substantially higher net annual income than the poor saps who are new to the landlord business.
Our purpose here is not to opine on whether Proposition 13 should be overturned, modified, or remain as is, but rather to point out how legislation (whether intended or not) can create a highly unusual situation where owners of an asset assign a much higher value to it than potential buyers. We believe this to be a primary reason for the increase in California real estate prices far in excess of inflation, even in the face of an exodus of both workers and retirees from the Golden state. Homeowners who are now enjoying very low taxes are naturally reluctant to sell, creating a scarcity of supply in the market. It also explains why California has very high state income and sales taxes. Like the Iron Bank of Braavos, Sacramento will have its due.
In a way, the effect of Proposition 13 is similar to the frequently-floated idea of having a variable long-term capital gains rate dependent on the tenure of ownership designed to incentivize investors to hold assets for longer periods. While it may sound nice in theory and perhaps give a one-time boost to asset prices, it would probably result in a lower level of capital being allocated to its highest and best use.