Game theory and cooperation in real estate

I recently had the opportunity to help out a few friends who found themselves in an awkward situation.  They both wanted the same house and both were negotiating with the owner to buy it.  The owner asked both parties to put in their highest and best offer.

I did some research and thinking about it.  If both parties put in their highest and best offer, one of them is likely to pay as high as they possibly can.  And all that money, of course, goes to the seller, which also raises housing prices and taxes in that neighborhood.

An auction is a better situation for the buyers, but not as good for the seller.  This is because each buyer can stop at any time and they know what the other one is bidding.  In a highest and best, you never know what the other party will offer so you bid as high as you can.

One option is that both parties sit down and come to consensus on who should receive the property based on who is the best fit, optionally negotiating an amount that the one who gets the house pays to the one who doesn’t.  This option is quite tricky and requires a lot of trust, but if successful offers the best results and both parties can walk away from it at any time, albeit with some information revealed.

The option we decided upon was to hold a private auction between the two bidders.  The winner would get the property for the starting bid, which was a price we knew the seller would accept.  The winner would pay the loser the difference between the winning bid and the starting bid.  So, if the starting bid was $100,000, and it was bid up to $110,000, then the winner would buy the houes for $100,000 and pay the loser $10,000.

Another way to look at this option is that you are bidding on what it is worth for the other party to walk away.  This has a very different psychological feeling to it though.

One problem with payments between the winning and losing bidder is that these payments can’t be bank financed.

So we all sat down together and talked for a long time about the house, and drew up some “handshake agreements”.  Each party went off to discuss the options privately.  It almost looked like it wasn’t going to happen, but then they agreed and we started the auction.  My heart was beating fast and I was quite nervous even though I didn’t have anything at stake!

Then the auction ended, one party was declared the winner, and when the sale went though, the winner paid the loser.  I can’t reveal exact amounts here due to a confidentiality agreement, but it saved the winner a substantial amount of money, and the loser got something out of the deal too!

This experience has made it clear to me that cooperation and negotiating in an agreed upon way with each other is far better for both bidders than going with a secret highest and best offer – if the parties trust each other, or have a trusted third party.

Maybe I should create some sort of business that brings buyers together to figure out the best deal for them.  Or maybe you should.

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