Perceptions and Motivations of the Negotiators
When two parties enter into a negotiation, they hope to reach agreement and close the deal because negotiations without a deal are a complete waste of time for all parties involved. The one goal both parties have in common is that they both want to close a deal.
Understanding what makes deals happen requires an understanding of the perceptions of the parties, and the motivations for action these perceptions create. Each party entering into a negotiation has (1) perceptions of the value of the property, (2) a belief about the direction of market pricing and (3) a sense of the motivation of the other party in the negotiation. Depending on what buyers and sellers believe about these three issues, they will adjust their bids and asking prices to try to make a deal happen. The greater the degree of alignment between the perceptions and beliefs of the two parties, the more likely a transaction is to occur.
Perception is reality for each individual, but that does not mean that each party to the negotiation shares the same reality or that either parties perceptions match objective Reality. This was nowhere more apparent than with the perceptions of value both buyers and sellers had during the Great Housing Bubble. The parties to transactions during that rally were aligned with their perception of value and both parties where totally incorrect. When prices started to fall, the perception of buyers changed before the perception of sellers did. When these parties began living in alternate realities, deals could not be reached, and transaction volume declined dramatically.
Comparable Sales and the Perception of Value
Sellers almost universally believe the value of their homes is greater than its actual fair-market value. Buyers generally have to be convinced that home values are greater than what they are willing to offer. Once the parties begin to negotiate, the seller usually must lower their asking price and a buyer must raise their bids for a transaction to take place. The actual fair-market value for any property is the price the parties to the transaction agree upon.
Listing brokers will often pander to the fantasies of sellers to obtain the listing. The broker knows the property has little or no chance of selling at a ridiculous asking price, but they take the listing to provide the seller with a wait-and-see opportunity to prove that the asking price is too high. After some period of time, the broker will go back to the seller and prompt them for a price reduction to meet the market.
Buyers will generally offer less than they believe a property to be worth to give themselves room to increase their bids without overpaying. Savvy buyers will establish a maximum bid before they enter the negotiation. If they can get the property for less, they consider it a bonus, if they bid up to their maximum offer without getting the property, they stop bidding and move on to their next-best alternative.
Buyers and sellers do not perform this negotiation in a vacuum. The final sales price the parties agree upon will generally be close to the sales prices of similar properties in the market area. These similar properties are what is known as comparable sales, or “comps” for short. Comps serve as the basis for negotiation for two main reasons: (1) financing is limited based on comparable sales, and (2) if buyers bid too little, or if sellers ask too much, each party has better alternatives to closing the deal; sellers can wait for a better offer, and buyers can find a similar property with a more reasonable seller. Each party to the transaction must be aware of their best alternative to a negotiated agreement because they may need to pursue other prospects.
The Problem of Cherry Picking
Picking comparable sales to establish a basis of comparison is as much art as science. Each party could select comparables they believe best serves their perception of value by “cherry picking” either the highest or the lowest sales to exaggerate the base value. If one party can convince the other that the basis for negotiation is 5% higher or lower than what it really is, then the successful cherry picker will make 5% more on the deal. The incentive to cherry pick is strong.
One approach to solving the cherry picking problem is to obtain an appraisal from a neutral third party; however, appraisals are not free, and the buyer is generally the one responsible for paying for it. Appraisals are rarely ordered during the initial stages of a negotiation, so they seldom work to overcome cherry picking.
Another approach is to obtain a Broker’s Opinion of Value to establish a base value. Unfortunately, brokers being agents of either the buyer or the seller are not neutral third parties. Brokers have a strong incentive to cherry pick to serve their clients.
Broker Duplicity and Failed Transactions
Brokers are primarily motivated to make a transaction occur because they generally do not get paid otherwise. Secondarily, they are motivated to obtain the best possible price for the party they represent; they have a fiduciary duty to serve one party to the transaction (although they can serve both in a dual agency situation). Many sales agents believe deceiving the other party in a negotiation is an appropriate tactic justified by their fiduciary duty. Realtor duplicity contributes to the impression in the general public that real estate agents cannot be trusted. Many cannot be.
The reason for the manipulation and deceit among unethical Realtors is that the techniques they use alter the perceptions and motivations of the other party in a negotiation. When these techniques are successful, buyers raise their bids or sellers reduce their asking prices. When these techniques fail—which often occurs—the use of these techniques so offends the other party that a deal that might have otherwise occurred does not go through; that result serves neither party, and it can be argued it is a violation of an agent’s fiduciary duty.
Honest Brokerage Establishes a Value Range
The best solution to the problem of establishing a base value for negotiation is for the broker to provide an honest and neutral opinion of value similar to an appraisal. If a broker prepares the opinion of value in such a way that it could serve the buyer or the seller, both parties to the negotiation can agree on a range of pricing within which the negotiation can take place.
For example, if a particular property has a range of comparable values from $450,000 to $550,000 with an average of $500,000, this information can be presented to both parties. Both can agree that the current comparable value is somewhere in this range as each one could make arguments for one extreme of the other.
The range of comparable sales values does not necessarily dictate a range for negotiating the deal—the initial bid and asking price do that—but it does serve to anchor the negotiations to a range of values that reflect the realities of the current market.
Trend of the Market
Sales prices for properties change over time. In most real estate markets, these prices go up with increases in wages among those who live in the market area. In California, we are prone to bouts with irrational exuberance and price volatility. Instead of slowly climbing prices like stable markets in the Midwest, Californians must cope with markets that can quickly move both up and down. The current trend of the market—if widely understood and accepted—distorts the perception of value and motivates buyers and sellers to stay ahead of the trend. In a rising market buyers are motivated to raise their bids and sellers are motivated to ask over comparable sales values. In declining markets, sellers (who accept reality) are motivated to lower their asking prices and buyers offer bids lower than recent comparable sales.
Motivation of the Other Party
Professional poker players spend hours studying people’s reactions to try to elucidate the cards their opponents are holding. In poker if players can determine what their opponents believe about the strength of their hands, they gain a significant advantage over the other players. If you know the motivations of the other party in a negotiation, you can respond by concealing your own motivation in hopes that the other party will either raise or lower their pricing to come to you. This is not deceitful; it is sound negotiating practice.
The risk of divining the other party’s motivations is that the perception could be incorrect and this may result in failing to complete a deal that otherwise might have gone forward. If parties to a negotiation are strongly motivated but pretend not to be, failure to complete a deal can be very frustrating. For anyone who has ever fallen in love with a property, not raising their bid to close the deal and then losing the property can be very disheartening. For any seller who desperately wants to get out of a property but fails to lower their price to meet the market, watching a buyer walk away is disappointing.
To try to gain advantage in this part of the negotiation, people often ask why the other party wants to buy or sell. Listing agents will almost universally tell buyers some story that makes the seller look less motivated than they really are. Buyer’s agents will tell the seller that the buyer is interested, but not too interested or “in love” with the property. Each side looks to gain advantage over the other by disguising their motivation. Sometimes this practice kills the deal, but sometimes it results in a significant monetary benefit to one party.
Comparable sales and the Negotiating Range
Comparable sales represent an anchor point in the negotiation, and the trend of the market tends to push future transactions in the direction of the current market trend. Understanding this dynamic provides a framework for buyers to present their bids and sellers to quote asking prices. Once an asking price is in the market and an offer is made on a property, the two prices establish a negotiating range. If the seller and buyer move to a common point within this negotiating range, a transaction will take place. If the buyer fails to raise their bid, or if the seller fails to lower their asking price, and the two parties do not find common ground, a deal will not take place.
The final sales price will generally be within a tight range around the price of recent comparable sales, regardless of what fundamental values may be. It is extremely rare for a property to sell for more than 15% below comparable sales prices. There is usually enough buyer competition that sellers will simply hold out for a better offer. It is also rare for a property to sell for more than 15% above comparable sales prices because lenders will not finance the additional sums. To overpay for real estate, buyers must close the deal with their own money. Most buyers either cannot do this, or they chose not to and go bid on other properties. Few properties sell for prices on the extremes, and most sell for near comparable sales prices. In bull markets, these sales are above recent comps, and in bear markets they are below.
Understanding the range of potential transactions is important because it goes to the core of two behaviors that waste time and effort for everyone involved: lowball bidding and ridiculous asking prices. There are many buyers out there looking for a real bargain. Bidding 30% under comparable sales is not going to result in a transaction. Some do this to try to establish a negotiating range and split the difference hoping to get the property for 15% under comparable sales. It does not work. During the deflation of the housing bubble, many bid 30% under comparable sales because they speculated that prices were going to drop 30% from current comparable values. Correct as this assessment was, it did not mean that sellers were going to sell for those values. If a buyer believes prices will fall more than 15% from current comparable sales, they are better off not bidding on properties and waiting for prices to drop.
On the other extreme is the seller asking for a ridiculous price more than 30% over comparable sales. A property priced that high will sit on the market forever and be an embarrassment for the seller and the listing agent. If the seller believes the market is going up and that they may obtain this price in the future, they are better off waiting for that future to come because a property will not sell for 30% over comps in any market.
Seller Urgency and Response
Why do sellers lower their price? The most obvious reason is that they know if they do not, they will not sell their property, but a more nuanced explanation is required to really understand what is going on. Once a seller has established an asking price, greed motivates them to keep it as high as possible. Once a buyer has made an offer, fear motivates a seller to lower the price to close the deal. The battle between greed and fear is the essence of a seller’s struggle.
If the seller perceives their asking price to be “fair” they are not strongly motivated to lower it because they believe any buyer who will not agree to their asking price will be replaced with a buyer who will. This is particularly true in a rising market. To the seller with a “fair” price, it is only a matter of time before a buyer shows up willing to pay their price. It doesn’t matter if the price is fair; it only matters if the seller believes it is. If the price is not fair and the seller is delusional, no buyer will show up to pay how much the seller wants, and no transaction will take place. Denial and delusion distort perception and prevent sellers from doing what is necessary to sell their property.
If the seller perceives their asking price to be fair, but they also recognize the trend of the market is down, they will be much more motivated to lower their price quickly to find a buyer. This is a rational fear because the longer they wait to find a buyer, the more money they lose to declining prices. Of course, this presupposes that sellers recognize the market downtrend and do not believe the market is currently at the bottom.
Buyer Urgency and Response
Why do buyers raise their bids? Again, the most obvious reason is that they know if they do not, they will not get the property because they will either be outbid, or the seller will not lower the asking price to meet their bid. There are a number of motivations buyers have for increasing their bids, and these motivations emanate from their perceptions of (1) scarcity, (2) market trend, (3) bidding competition, (4) property value, and (5) property desirability. Manipulative real estate agents use techniques to generate fear in buyers and alter the buyer’s perceptions and motivate them to increase their bids.
If buyers perceive another property will be available if the current deal falls through, they feel no sense of urgency to raise their bid to close the deal. In order to provide that motivation—through perfidy—Realtors taunt buyers with the idea that they should “buy now or be priced out forever.” If buyers believe this fallacious nonsense Realtors peddle, they will believe properties are scarce, another deal will not come along, and they should raise their bids to close the deal. It doesn’t matter whether or not this perception is reality, if buyers believe properties are scarce, they will be more motivated to raise their bids and close the transaction.
If buyers perceive the market trend is moving higher, they may believe they will be priced out, but they may also have the more rational belief that if they do not bid higher, someone else may out bid them. If the bidders they are competing with are strongly motivated—for whatever reason—a higher bid may be the only way to secure the property. In the grander scheme, it may be in a buyer’s interest not to buy under these circumstances because such market conditions are indicative of a real estate bubble.
If buyers perceive the market trend is down, they know they can either get a better deal on the property they are bidding on or they will get a better deal on another property if the current negotiation fails. This is perhaps the most difficult problem for a realtor to overcome. When it really is in a buyer’s best interest to wait or make cautiously low offers, the motivation to increase bids is practically non-existent. The answer to this problem for Realtors is to publicly call the market bottom every few months even when they know it is not going to happen. Bidders must be convinced that prices are going to rise again soon or there is limited motivation to bid on properties and even less urgency to raise bids.
If buyers perceive they are the only one interested in a property, they are far less motivated to increase their bids because there is no competition, and the negotiation is purely between the bidder and the seller. Realtors have a tactic for this problem; they lie and tell bidders that there are other offers on the property. This is perhaps the most commonly told lie in the real estate industry. If buyers believe it, it renews the sense of urgency for buyers to increase their bids.
If buyers perceive their bid is “fair” relative to the value of the property, they are not motivated to increase their bid. Nobody wants to overpay for real estate. This is where cherry picking comps and arguments about the investment value of real estate are used to convince a bidder that their perception of value is too low and that their bid is not “fair.” The National Association of Realtors spends huge amounts of money to tout the financial benefits of home ownership to convince people homes are more valuable than they really are.
If buyers perceive that a property is uniquely suited to their needs, if they “fall in love” with the property, they are highly motivated to increase their bids to obtain the property. This is the ultimate fantasy of every seller. Once a buyer is in love with a property, they will raise their bids until they either have the property or they reach the limit of their resources. The obvious advice to buyers is not to fall in love with any property you want to get for a “fair” price. For most buyers, this is easier said than done. Many buyers will not even bid on a property unless they are “in love” with it. This behavior almost guarantees overpaying for a house.
The Dynamics of a Transaction
Once a property is offered for sale, and once a bidder presents an offer in a realistic range to complete a transaction, the negotiation for real estate begins. The prospective buyer and the seller generally communicate through intermediary agents through informal messages and formal written offers and counteroffers. The informal messages take two main forms: (1) attempts to solicit information on the motivation of the other party, and (2) attempts to increase the motivation of the other party to either raise their bid or lower their asking price. The informal communications are an integral part of the art of the deal. The formal communications through offers and counteroffers are presented in the context of the narrative provided through the informal communication.
It is the exchange of information through the informal lines of communication that often determines if a transaction will occur. If both parties are not motivated, and the spread between the bid and the ask is wide, no sale will occur. In these circumstances, the motivations of the parties must be increased to meet somewhere in the middle. That is the purpose of the informal communication. If both parties are motivated, then a deal is likely to occur. The price point where they meet is determined by the skill of the negotiators. In these circumstances, concealing motivation results in a transaction with a favorable financial result for the concealing party. It is like the poker player who learns to hide their emotions in order to prevent the other party from reading the strength of their cards.
In reality, the only meaningful communication between the bidders and sellers is the written offers and counteroffers because it is the only actionable communication. Most people do not realize that asking prices are meaningless. A seller is under no obligation to sell a house if a buyer agrees to pay an asking price. In contrast, a written offer is actionable. If a seller agrees to a written offer, a valid contract is formed, and the buyer is obligated to buy the property (subject to contingencies). Once written offers and counteroffers begin going back and forth, acceptance of the written offer by the other party forms a contract, and the deal moves into the escrow process.
Summary
The process of negotiation is a study in human psychology. It can be readily understood, and the process can be mastered. It requires emotional control and an evaluation of reasonable alternatives to completing the deal. The parties to the transaction establish a range of valuations and then negotiate a price somewhere within this range depending on the relative motivations of each party. If the parties are motivated enough, a transaction takes place; if they are not motivated enough, no sale occurs. Seeing the process as one of perception and motivation provides a deeper understanding of dynamics of the process, and it may provide the edge needed to gain financial advantage. To quote Sun Tzu from the Art of War: “If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained you will also suffer a defeat. If you know neither the enemy nor yourself, you will succumb in every battle.”
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