Bob’s new house was damaged in a storm. He spent $20,000 in insurance deductible and repairs not covered by insurance to fix the house. The house was valued at $400,000 before the storm. Since Bob spent $20,000 on repairs, would the market value of the house increase to $420,000? The storm reduced the value of the house significantly and the repairs restored the house to the same condition it was before the storm. The repairs restored the price back to $400,000. From the buyer’s perspective, the house is the same as it was before the storm. so why would he pay an additional $20,000 for it? He wouldn’t. The amount spent on repairs is a sunk cost that cannot be recovered. Bob can insist on passing the cost of repairs to the buyer by selling it for $420,000, but he would most likely not be able to sell it.
A year later, house prices increase by 5%, so Bob’s house is worth $420,000. It might seem that he recovered the cost of repairs, but that is not true. The price of the house would have gone up anyway if the storm had not damaged the house. The price increased due to the increase in demand for property, not because of the money spent on repairs. So the amount spent on repairs is still considered a sunk cost.
Sunk costs are money you spent that can never be recovered.
Source: Save Invest Compound by Nazim Rahman
