Introduction

The home renovation and remodeling market has cooled off as higher interest rates have naturally hampered the financing that enables it. But the market has still stayed remarkably strong, with spending above 2022 levels with strong consistent projections despite high borrowing costs. What’s driving this renovation spending by homeowners and how much of it can be considered investment activity versus consumption? Most importantly, how can financial advisors help homeowners think through renovation decisions with reasonable processes that minimize common biases in how people think and feel about money. For many investors, home equity represents their largest asset, and any changes to primary or secondary homes represent major investment decisions that can involve hundreds of thousands of dollars or even more.

In this blog we’ll discuss both the rational economic reasons and psychological biases behind home renovation decisions in the current economy, and how advisor awareness and inquiry can help guide investors to make the best choices to meet their personal financial and life goals.

Why are home renovations such a complicated financial decision?

Like many real estate decisions, home renovations represent a complex combination of consumption and investment. People typically renovate their homes to make them more utilitarian and comfortable, for a variety of reasons including family, health, recreation, safety, transportation, and even their furry friends.

Yet any renovation also has implications for the underlying value of a home should the owners ever choose to move, and that value is determined by its value to buyers, not to the sellers who made the renovation decisions. Just because a homeowner loves building an addition with virtually no windows doesn’t mean that potential buyers will find that attractive. This is why advisors can play an important role in helping clients separate value from market value. Renovations that create personal value but not market value may still be right move for a client, particularly when there are no plans to ever relocate, because the joy, comfort, safety, or health that they would receive is important. But advisors can help greatly clients avoid rationalizing such renovations as investments when the renovation cost will not be recovered during resale.

Why are home renovations so common now?

High interest rates originating from the Federal Reserve’s monetary tightening policies have indeed raised the cost of renovations for most homeowners. For those owners relying on home equity or other personal loans to fund projects, the cost of that financing can be much higher than a few years ago during the pandemic era that saw mortgage rates below three percent. Even for wealthier homeowners that can pay with cash, the cost of doing so is higher because of the significant foregone investment returns available to them in even the safest portfolios of treasury-backed securities.

1. Limited Housing Supply: The low housing inventory that already existed a few years ago has gotten worse, as homeowners locked into historically low fixed interest rate mortgages balk at moving when it implies at least a doubling of mortgage rates and the monthly payments they imply. This reluctance to move due to mortgage rates exacerbates the housing market problem as undersupply drives up prices even more. Higher interest rates have also restricted new housing construction, which has long been constrained by zoning restrictions on multifamily homes.
2. ‍ Increased Home-Focus After the Pandemic: The COVID-19 pandemic clearly changed how people live and work, increasing their need for comfortable and multifunctional living spaces that accommodated both work and leisure. Many people needed dedicated home offices, better private outdoor spaces, and more functional kitchens and bathrooms to accommodate remote work and a shift to home activities. Even though the pandemic ended, the changes it evoked were sticky, with workers reticent to give up their new remote work schedules.
3. Although renovations might continue to be great decisions if someone continues to spend high proportions of their time at home, those renovations might be driven by an irrational availability heuristic, where people make decisions based on the examples that readily come to mind. When a homeowner considers how to allocate their budget, the home features that they see for the majority of hours are likely to jump to mind far before investments that are less available and tangible.
4. ‍Higher Inflation Makes Immediate Home Investments Attractive: With inflation continuing at levels above the Federal Reserve’s two percent target, capital investments in personal property can be attractive for both rational and psychologically biased reasons. If home renovations indeed deliver increased home value, homeowners might expect the value of those renovations to increase proportional to inflation that might instead devalue other assets. Continued inflation also reduces confidence that the Federal Reserve will reduce interest rates in the near future, which implies mortgage and home equity interests are unlikely to fall much.
   • Psychological biases can accelerate the already reasonable desire to invest in home renovations. Anchoring bias might unreasonably reduce expectations that interest rates might fall in the future, leading them to renovate now rather than retain the option to upgrade to a different home in the near future. This belief could be exacerbated by positive recency bias as homeowners expect rising rates to continue simply because this was the recent trend. Some homeowners might believe rates will fall because of the gambler’s fallacy, another recency bias where people think recent events are likely to predict the opposite trend in the near future. People are complicated! As a financial advisor, the key is to ask questions to understand how investors are reasoning through the home renovation decision.

1. ‍Sustainability and Energy Efficiency Movements: Improvements in home energy efficiency and sustainability can be great investments both in reducing recurring utility costs and improving future home sales prices. Federal, state, and utility incentives to install heat pumps, appliances, windows, or geothermal and solar energy systems can make the economics of these investments particularly attractive, as can homeowner desires to reduce their environmental footprint. Regardless of these legitimate reasons, people can struggle to think through these choices carefully for several reasons. First, their renovation decisions might be influenced by the bandwagon effect, where homeowners undertake renovations in these areas because they see others doing so and they want to be viewed favorably by society. Homeowners might also jump to upgrade systems because of the fear of missing out on current incentive programs, even if those incentive programs aren’t significant enough to justify the expense.

 Other biases to consider

1. Status quo bias is an emotional bias that makes people reticent to changes in their current situation, even when those changes are clearly needed or beneficial. This bias emerges when homeowners take on costly renovations to existing properties, when changing homes would better meet their needs at a lower cost. With recent legal settlements by the National Association of Realtors, the transaction cost of moving homes (through commissions) is certain to decrease, improving the relative benefits of changing houses compared to renovating existing homes.
2. The endowment effect is closely related to status quo bias, and makes people overvalue the home they currently own relative to nearly identical homes that they could buy. Like status quo bias, the endowment effect makes it more likely to renovate instead of move, even when renovation makes little financial sense.
3. The sunk cost fallacy leads people to falsely conclude that past investments in a home should heavily influence future renovations. Is a homeowner continuing to make costly retrofits to an old home because they already invested large sums to keep the home functional?
4. The prospect of a high return on investment from renovations can often be exaggerated by the overconfidence bias. Homeowners might believe their renovations will yield higher returns than average, encouraging spending on extensive upgrades that might be idiosyncratic to their tastes. People tend to overvalue their tastes, relative to others, and are often poor at recognizing that the features and styles they love are not shared by others such as future homebuyers.
5. Like with most financial expenditures, many people might overspend on home renovations because their optimism bias blinds them to potential adverse events such as economic downturns, job loss, health concerns, and housing market crashes. Home equity loans, for example, can trap a homeowner in their property if a housing market collapse drives their debt load above the new appraised home value.
6. Conformity bias can motivate homeowners to upgrade or renovate their home to match recent trends in design or architecture. Although such changes might be popular in the current housing market, they might not be in the future when the homeowner decides to sell. Trendy renovation choices can backfire when trends change quickly in the future and those renovations end up reducing home value.
7. Projection bias can lead homeowners to underestimate how much their needs, preferences, and behaviors might change in the future. Expecting their future selves to want and act identically to their current self can hurt their ability to plan for the future, leading to short-sighted decisions and poor long-term planning. Extensive renovations that might not fit their lifestyle in the future can be poor investments both financially and personally.

 Advisor Recommendations:

1. Engage clients in conversations about current and future plans on renovations and remodeling while seeking to understand their motivations and goals. Ask them how they’re thinking about any projects and how that will improve their life. Then ask them for their thoughts on how a project might return value to their home, and how leaving the home in the future is influencing their thought process. Avoid judging choices with low investment value that will bring personal consumption benefits over a reasonable time horizon.
2. Once the goals are clear, help clients understand the implications of a realistic budget given their financial situation. Help them understand not only the typical cost of materials and labor but also often overlooked expenses like eating out during a kitchen remodel or staying elsewhere if the renovations are extensive. Ask them how they would react to unexpected circumstances like cost overruns, helping them understand the sunk cost fallacy and escalation of commitment before the costs are sunk. Encourage clients to plan for cost overruns when evaluating budgets. Lead with questions to help them recognize any concerns themselves.
3. Ask clients whether switching houses might be an alternative to major renovations, and how they have thought through this process. Help them understand what, if any, alternatives might exist to renovating their existing home.
4. Consider scheduling a wellness check while any major renovation is in place, where you can help them step back and evaluate any changes in their financial situation or the projected renovation costs.
5. Walk clients through the options for financing a project, including tax implications if relevant. Make sure they understand the opportunity cost of paying for renovations with cash that might otherwise be invested elsewhere.
6. Discuss any financial risks created by illiquid assets during renovation. Would the client be financially stable if something happened during a major renovation, where a home sale might be particularly difficult?
7. Ask clients to consider what type of home they might want in five or ten years? Help them evaluate whether their future selves are going to love the changes they’re making today, and if not, what the financial implications are for their future selves to rectify that contrast.

Conclusion

The continued strength of home renovations, even amidst high interest rates, is a function of economic factors and human psychology. Behavioral biases can significantly impact renovation decision-making, often leading to choices that are neither financially wise nor meeting the goals, desires, and lifestyle choices of clients. An advisor who understands both the economics and these potential biases can lead conversations that help clients discover their own fears, motivations, expectations, and blind spots as they make important decisions about one of their biggest assets.