AUCTIONS IN THE REAL ESTATE MARKET A REVIEW

Transcription

1 AUCTIONS IN THE REAL ESTATE MARKET A REVIEW Samuel Azasu Building & Real Estate Economics KTH Stockholm February 2006 Working Paper No. 55 Section for Building and Real Estate Economics Department of Real Estate and Construction Management School of Architecture and the Built Environment Royal Institute of Technology

2 EXECUTIVE SUMMARY Auctions have grown in importance as a way of trading not only in art and antiques, but also a wide range of goods including offshore oil and telecommunication licenses, real estate, procurement contracts and even simple consumer goods. This paper briefly reviews the basic auction types, and bidder behavior under the various auction types. It further explores the relationship between the auction types and the important properties that a good auction must have. Four basic types of auctions are used depending on the good and the objectives of the auctioneer: English, Dutch, first and second-price sealed bid auctions. An important inference from previous research on auctions is that good or bad auctions arise from two design issues: how to attract bidders and avoid collusion. Auctions are used in the real estate markets across the world even if they are not that widespread. Compared to private negotiations, real estate auctions have been shown to result in higher prices for similar houses in good condition, and in favorable locations. It could arguably thus support a vibrant housing market by creating the right incentives for property to change hands. However, in declining markets, and for distressed properties and/or for dissimilar properties, the reverse could happen. The current Swedish ascending auction may be vulnerable to collusion and consequently deter bidders. The solution may be to explore design refinements rather than abolish auctions altogether. The paper also reviews research on online auctions. The paper concludes by identifying issues for further research. 2

3 Table of contents 1. Introduction and definitions Auction theory Optimal bidding behavior Do institutional details matter? Auctions in practice Auctions in general Auctions in the real estate market Auctions in the real estate market in Sweden Factors affecting successful auctions in real estate ICT and online auctions Conclusion...12 References

4 1. Introduction and definitions Auctions are relatively recent phenomena as a normal way of trading real estate. However, their importance and role in trade in other assets have been around for some time. Research into auctions has grown, underlying its importance as a market mechanism. This paper briefly reviews the role of auctions in the real estate market. It will explore the question of whether auctions are preferable to sales by private negotiations. It will also identify factors that will determine successful auctions from the seller s perspective. The central argument, from a review of the relevant literature, is that good or bad auctions are a matter of design (Klemperer, 2002). Baye (2003) defines an auction as an arrangement by means of which potential buyers/sellers compete for the right to buy/sell a good/service. Actions can be modelled as games, which means the auctioneer and bidders are players, with strategy profiles and payoffs for each strategy profile (Milgrom, 1989; Baye, 2003). Depending on the roles of the bidders and auctioneers, the strategies of the players could vary. When the auctioneer is a seller, his goal will be to sell at highest possible price. If he is a buyer, he must aim at buying at the lowest possible price from a set of potential suppliers. Conversely, when bidders are buyers, they want to buy at the lowest possible price. When they sell, it is rational for them to sell at a lower profitable price than rival suppliers. Auctions are classified according to the timing of bidder decisions (sequential or simultaneous bids), and the amount the winner is required to pay. Using these definitions, Milgrom (1989), Baye (2003), and Klemperer (2003) identify four basic auction types: English auctions First-price, sealed-bid auction Second-price, sealed-bid auction, and Dutch auction The English auction is probably the most familiar. Baye (2003) described it as an ascending, sequential-bid auction in which bidders observe the bids of others, and decide whether or not to increase the bid. This auction ends when a single bidder remains; this bidder obtains the item and pays the auctioneer the amount of his bid. There are a number of variants of the English auction 4

5 The open outcry auction, where bidders call out prices The silent auction where the auctioneer calls out prices The Japanese auction where bidders hold down buttons The first-price, sealed-bid auction is a simultaneous-move auction in which bidders simultaneously submit bids on pieces of paper. The auctioneer awards the item to the highest bidder, who pays the amount of bid. A second-price, sealed-bid auction is a simultaneous-move auction in which bidders simultaneously submit bids; the auctioneer awards the item to the highest bidder, who pays the amount bid by the second highest bidder. A Dutch Auction is a descending, sequential-bid auction in which the auctioneer begins with a high asking price and gradually reduces the asking price until one bidder announces a willingness to pay that price for the item. It is important to emphasize that apart from English auctions, players bidding without knowing what the other players have bid characterize all the other auctions. 2. Auction theory 2.1 Optimal bidding behavior An important issue explored by theorists was how rational bidders would behave under various auction setups. Milgrom (1989) identifies Vickrey (1961) as being the first to systematically investigate this issue. According to Milgrom, the bidder in a 2 nd price, sealed bid auction faces a problem identical to the bidder in an English auction. For both bidders, the only problem each has to solve is the highest price at which they will be willing to claim the good being sold by auction. The optimal behaviour of each bidder leads to each offering to buy at a price equal to their bids. Milgrom (ibid) also demonstrates the equivalence of Dutch and 1 st price auctions by showing that when Dutch and 1 st price, sealed bid auctions are modelled as strategic form games, the games are identical, i.e., they have the same reduced normal form. The sets of strategies are identical and the outcome rules that change strategies into allocations are identical (the solution concepts are identical). The identity of the winner and the price the winner pays will be the same for the two auctions. In an English auction where the value of the object is private information to respective bidders 1, optimal bidding requires each bidder to bid until the bid exceeds his/her private valuation. At equilibrium, the item goes to the bidder with 1 With rival bidders valuations being independent 5

6 the highest valuation for a price equal to the second highest valuation. Milgrom notes this outcome is efficient (p.8). Vickrey (cited in ibid) shows the equivalence of this outcome to that of a sealedbid, second price auction with private independent values. Milgrom notes here that if bidders are price-takers, the price paid by the winning bidder depends on competitors bids alone (p.8). He further explains that a bid is just another way of stating which price offers a bidder is willing to accept. This implies that bidders should accept offers, up to their bid for the object, not more. The dominant strategy is thus for all bidders to bid their true reservation price, which makes it rational to accept offers below this bid and none above. The existence of a dominant strategy means one can submit a sealed bid in total disregard for rival bids. These characteristics make a second price auction a duplicate of the open outcry English auction. Apart from independent private values, optimal bidding behavior has been studied under conditions of affiliated values. In this case, the assets being traded are of equal value to the bidders. However, there s common uncertainty over factors such as, in the context of the housing market, future values, changes in neighborhood quality etc. This leads to a positive correlation between bidders values. The analysis of equilibrium when the independent private values assumption is relaxed is built upon a stronger concept of affiliation, a concept attributed to Milgrom & Weber (1982, cited in ibid). Affiliation implies that as a bidder s valuation rises, he expects others values to rise in the sense of becoming more likely. 2.2 Do institutional details matter? Given the equivalence of the major auction forms, one may then want to understand why certain forms are used under certain circumstances more frequently than others. One way to approach the issue is to see how much revenue results from each auction type. The revenue equivalence theorem basically answers this question by stipulating that the English, Dutch and sealed bid auctions yield exactly the same expected profit for every bidder valuation and the same expected revenue for the seller with independent private values. The next logical question, therefore, is how affiliation affects the auctioneer s ability to extract incremental profits associated with larger value estimates? Milgrom (ibid, p. 15) shows that while the total surpluses are the same for the English and the sealed-bid auctions for affiliated values, the bidder s expected payoff is smaller in the English auction and the seller s expected revenue is thus higher. The explanation is that if price paid by the buyer can be more effectively linked to exogenous variables that are affiliated with bidders private information, the bidders can be made worse off and the seller made better off. Thus if seller has 6

7 information about the object that would materially increase the bidder s valuation, then revealing this information is beneficial to the seller bidders will offer higher bids, resulting in a higher selling price, allowing the seller to extract the bidder s surplus. An alternative way suggested by Milgrom to compare auctions is on the basis of robustness, efficiency, transaction costs and immunity to cheating. Efficiency considerations apply not only to the final allocation of the good to the bidder but also include costs of bid preparation. Lucking-Reiley (2000) argues that optimal bidding in English auctions is simpler and more robust because it involves dominant strategies in the sense that any bidder s optimal strategy is unaffected by rivals bids. However, Milgrom (1989) notes that auctions are susceptible to bidder s colluding to win the bid and re-auction the product among themselves. The strategically equivalent second-price, sealed bid auction suffers from a weakness: the auctioneer may cheat by inserting a false bid if he finds the second highest bid to be too low; the auctioneer may also withdraw the good from auction if he finds the winning bid is very high, suggesting the good is perhaps more valuable than the auctioneer first thought. Lucking-Reiley (ibid) cites this as the reason for the relative scarcity of this type of auction. 3. Auctions in practice 3.1 Auctions in general As noted by Milgrom (ibid) and Lusht (1996), when the quantity to be supplied is specified in advance, English auctions are more prevalent. In the case of procurement contracts, sealed bid auctions are more prevalent. Some auctions generate a lot of money for the seller, while some auctions are vulnerable to collusion, resulting in lower revenues for the seller. According to Klemperer (2001, 2002), whether an auction makes or loses money depends on how successfully it is designed to attract bidders and prevent collusion between bidders. In the case of 3G phone licenses, he was able to show that design was the critical difference between the huge revenues realised in the UK auction and other European auctions. In a review of European 3G auctions, he points out that in principle, the ascending auction is flawed from the auctioneer s perspective because it allows rival bidders to signal plans to collude in latter rounds as well as issue threats to those who fail to go along with any intended collusion. He further notes that ascending auctions can deter entry from weaker bidders who know their bids can be topped by stronger bidders. 7

8 He contrasts this with a sealed bid which eliminates the possibility of signalling and punishment in furtherance of a plan to collude. In addition, the improved chance of winning encourages entry for weaker bidders, given the anonymity of the sealed bid process. The downside of a sealed bid auction is that sometimes bidders with lower valuations may win, leading to an inefficient outcome. Perhaps the most important point in Klemperer s review is that auctions must be tailored both to its environment and the designer s objectives. Thus in the case of the UK 3G auction a hybrid Anglo-Dutch auction was used. Stage one of the process involved an ascending auction, which removes the risk of inefficient outcomes. Once the bidding got to the stage where the number of bidders was one more than the number of licenses, a sealed-bid was used. The twin-advantages of changing the process were attracting entrants and raising revenue. This was in addition to deterring collusion. 3.2 Auctions in the real estate market A fundamental issue is how revenues from property sales by auctions compare with sales revenues from private negotiations. Lusht (1996) points out that up until the mid 1990s, research into this issue mainly compared sealed-bid auctions with privately negotiated sales, in spite of the fact that English auctions dominated all the other auction forms. Using data from negotiated sales and auctions in the Melbourne housing market from January 1988 to March 1989, he showed that the average price from auctions was 8 percent higher than from private negotiations. Besides, auctions tended to be chosen for newer houses in good condition. This viewpoint is partly confirmed for the Swedish market, where Eklöf and Lunander (2005) show that unlike conventional auctions, executive auctions often are used to sell less attractive houses. From a more general perspective, Bulow and Klemperer (1996) also show that a simple competitive auction with one more bidder will yield a seller greater expected revenue than an optimally structured negotiation with one less bidder. Thus if a house seller faces a number of potential buyers and the seller knows there could be an additional potential buyer, it is better for the seller to auction the house than negotiate. However, there have been differences in the extent of use of auctions in the real estate market as an alternative to negotiated sales. While they were used largely for disposing of real estate in bankruptcies cases, they have been used as an alternative sales method in the US up till the 1980s even though their use slowed after that due to the notion that they led to sales of properties at less than market value (Mayer, 1998). In contrast, auctions are an accepted mechanism for selling 8

9 residential real estate in Australia, Scotland, New Zealand and Sweden, alongside private negotiations (Lusht, 1996; Mayer, 1998; Eklöf & Lunander, 2005). Previous studies cited by Mayer show conflicting conclusions about the price effects of real estate sales by auctions. Whereas they sold in the US at a discount (Wright 1989, Gau & Quan 1992), in Australia Lusht (1996) found they sold at above market prices. Mayer (1998) tries to explain the discrepancy in terms of: Differences in market conditions - in Australia, auctions were used in rising markets, while the opposite occurred in the US market. Omitted variable bias observed high auction prices may have been due to an omitted attractiveness variable. The regressions may have thus wrongly attributed quality advantages to the sales technique. Mayer noted that if auctions led to sales of assets at a premium, it could only be because they took place in rising markets, with inexperienced buyers who overbid, exposing themselves to the winner s curse in the process. The price premiums may also have been due to the novelty of using auctions as a sales mechanism and the resultant media attention it generates. If the observed price premium arose for these reasons, infers Mayer, they should not be sustainable in the long run. If the research evidence from Australia showing auctions that auctions in healthy markets lead to higher transaction prices than private negotiations are anything to go by, then one can argue that auctions could support the development of a vibrant housing market. This is because they would provide the right incentives for market players, as long as the design flaws are detected and rectified. Lusht (1996) describes the auction process in Melbourne as follows: the listing agreement specifies the date of the auction, an advertising schedule and costs, the commission agreement, and a reservation price. The existence of the latter is public knowledge even though the actual price is not. The next step is to advertise and show the house to individuals and by open house. The auction is generally held at the property, during which the auctioneer may consult with the seller about a minimum acceptable price. When a sale is concluded, a 10 percent deposit is required, while the remainder is payable within 60 days from the sales date. Potential buyers make independent agreements with lenders prior to the sale. In the event that the purchase price exceeds debt or requirements, the purchaser can default on the contract. An important feature of the Melbourne auction is the open and legal use of seller/dummy bids in the auction process, creating a perception that it boosts prices. Another feature of the Melbourne auction is that unsold houses are unlikely to be auctioned a second time. 9

10 3.3 Auctions in the real estate market in Sweden Housing sales in the Swedish real estate market is characterized by auctions and private negotiations. The auctions are either conventional English ascending-bid auctions or executive auctions. The various brokerage firms organize the conventional auctions, while the Debt Enforcement Administration (Kronofogdemyndigheten) usually conducts executive auctions as the last step in the judicial process of debt collection. Since the English auction format is the standard format in the housing market, they obviously would suffer from the collusion and entry-deterrence problem. However, the design flaws may not provide sufficient grounds for its abolition as a market mechanism. Once again, we argue that if auctions could lead to higher prices than from private negotiations, then it could be useful for the development of a vibrant housing market. In that case, the way forward would be to explore ways of refining the design to eliminate these flaws. As shown above, the hybrid auction format used above for the European 3G auction provides a powerful example of how the current plain English auction can be improved. In a study of executive auctions in Stockholm, Eklöf and Lunander (2005) state that conventional auctions are often ascending-bid auctions, with the bidding procedure lasting for days. They point out that this gives potential buyers time to evaluate how their finances affect their chances of buying the object. They also state that brokers sometimes mediate loans for the buyer and bidders can condition their bids on successfully obtaining a loan. They rightly infer that this is financially risky than in executive auctions where the down payment, 25 percent of the value is lost if the winning bidder doesn t pay the rest. The second risk at an executive auction is what they called a real value risk: under executive auctions, the building is sold as is, so the seller cannot pull out of the transaction upon discovering brokers/sellers have withheld information about hidden damages to the property. Bidders at a conventional property auction do not have to deal with this risk. They also point out that the nature of executive auctions imply that buyers interested in normal property in the exclusive areas of Stockholm should not be expected to be interested in executive auctions of property in Stockholm. 3.4 Factors affecting successful auctions in real estate The primary issue in the use of auctions in real estate, it has been argued, has been how sales revenues from auctions compare to revenues from privately negotiated sales. However, as noted by Ong, Lusht, and Mak (2004), less attention has been paid to the conditions for auction success, defined as concluding a sale. 10

11 Using data from Singapore on auctions of residential property from 1995 to 2000, they find that poor market conditions diminish the probability of sale; however, the higher the potential number of bidders 2, and better the identity of the auction house the higher the probability of sale. Distressed properties were more likely to sell. They also find that more homogeneous properties (apartments and condominiums) are more likely to be auctioned. More centrally located properties were also more likely to be sold than properties in peripheral locations. It has to be noted that the preferred auction format here is the English ascending bid auction and that attitudes towards housing sales by auction is similar to that of the US (Asabere and Huffman, 1992 cited in ibid). Thus the number of residential sales by auctions was still relatively low by the late 1990s (ibid, p.5). Mayer (1998) in his comparative study of auctions in Los Angeles in the mid 1980s and Dallas during the late 1980s finds evidence to support an earlier theory (Mayer, 1994) that auctions sell property at a discount. Nevertheless, he also finds evidence suggesting that auctions are a viable sales strategy for sellers when the latter can hold large auctions and enjoy economies of scale in advertising and commission costs. 3.5 ICT and online auctions Online auctions are a growing phenomenon, with companies like e-bay attracting millions of visitors on a regular basis. Walley and Fortin (2004) formulate a model of online auction consumer decision process. They tested the extent to which factors such as auction reservation price, the disclosure or otherwise of the reserve price and the amount of initial bidding history in the auction impact the final sale price as well as overall interest in the auction. They found that the value of the reservation price, and its disclosure, have a significant impact on the final sale price. Their explanation was that the disclosure of the reservation price leads to an increased interest in the auction leading to an increased final selling price. Conversely, non-disclosure of a reservation price gives rise to the need to create interest in the auction, which only occurs if more bidders participate. Yet, they cite a previous study by Smith (1989), which shows that under conditions of increased participation, risk and competition averse bidders will withdraw at higher reserve price levels. They also found that the final price obtained is lower, as the average experience of the bidder rises. 2 An indicator of market interest 11

12 4 Conclusion Auctions have grown in importance as a way of trading not only in art and antiques, but also a wide range of goods including offshore oil and telecommunication licenses, real estate, procurement contracts and even simple consumer goods. Four basic types of auctions are used depending on the good and the objectives of the auctioneer. English auctions and second price sealed bid auctions have been shown to be strategically equivalent, as has first price sealed bid and Dutch auctions. Under conditions of independent private values, all the four auction types lead to identical revenue for the auctioneer. However, when bidders valuations are affiliated, the outcomes are a lot less certain. Klemperer s (2001) discussion indicates that the two most important issues in auction design are encouraging new entrants (usually in order to maximize revenue) and how to discourage collusion. Ascending bid auctions of houses are susceptible to collusion between bidders; bidders can collude to end an auction quickly at a low price or bid the price high enough to drive out other bidders. Thus if there is a strong belief among potential bidders that there are strong bidders who will eventually top their bids, they will be deterred from entering the bidding process. Some ascending auctions may also suffer from the winner s curse, causing especially weak bidders to bid cautiously leading to less than optimal prices for the seller. It may even worsen the entry deterrence problem, which then opens the door for strong bidders to collude. Sealed bids, notes Klemperer (ibid), are relatively immune from collusion since bidders cannot use their bids to send signals, unless the sealed bidding process is repeated a number of times among the same bidders. Since the outcome in this case is relatively uncertain, it is relatively advantageous for weak bidders to enter since they could win more easily than in an ascending auction. Klemperer (ibid) argues that the entry-attracting feature of sealed bids makes it harder to collude, rendering it competitive in the process. It is easy to agree with Klemperer s proposal for creativity in auction design. In the context of the housing market, his suggestion of a hybrid Anglo-Dutch auction in stages deserves consideration for the Swedish housing market since it achieves the twin goals of attracting entry 3 and discouraging collusion. Typical design problems occur when the auction process is not transparent in the sense of bids not being transparent, public, and with no deadline, then there is a real risk that the auction could lead to irrational behaviour on the part of both bidders and auctioneers. For example, when bids are not binding, people can bid 3 Of weak bidders who need housing, which also means sellers can get attractive prices. 12

13 on several objects, and take back their bids at a later stage. When the bidding process, especially in an English auction drags on for too long, bidders have the time and opportunity to collude and drive out the competition. The seller can also stop the procedure at a later stage, or award the good to a buyer without having to explain why a particular buyer was chosen. Auctions in real estate are not that widespread and their use varies across countries. While the experience from Australia shows it leads to higher house prices than the price from negotiated sales, other research has shown that their use may lead to assets being traded at a discount or a premium depending on market conditions. Indeed market conditions may improve or reduce the chances of a successful auction, defined in some of the literature as the probability of sale. Quality differences may also play a part. Research from Singapore confirms traditional theoretical predictions that the number of bidders is critical. In addition, the identity of the auction house increases the probability of sale. They also find that more homogeneous properties (apartments and condominiums) are more likely to be auctioned. More centrally located properties were also more likely to be sold than properties in peripheral locations. The Swedish auction system is obviously vulnerable to the twin problems of collusion and entry deterrence. However, the solution may not be to abolish it. Instead, an initial research priority will be to investigate how to eliminate the design weaknesses. For example, the feasibility of the hybrid Anglo-Dutch system can be tested and compared with the current ascending bid system. It will also facilitate comparisons between the Swedish practice and what pertains in other markets. The sale of a growing number of items is being done using online auctions. Recent research has shown that the value of the reservation price, and its disclosure, has a significant impact on the final sale price. What will be worth exploring, is how this would affect the feasibility or otherwise of an online auction system real estate. It will also be useful to explore and compare the alternative sales mechanisms for real estate in mature and stable markets. 13

14 References Baye, Michael R. (2003) Managerial Economics and Business Strategy. International Edition: McGraw-Hill, New York. Burlow J., & Klemperer P. (1996). Auctions versus Negotiations. The American Economic Review, 86(1), March, pp Eklöf M. & Lunander A. (2003). Open outcry auctions with secret reservation prices: an empirical application to executive auctions of tenant owner s apartments in Sweden. Journal of Econometrics, 114. pp Klemperer P. (2001). How (not) to run auctions: the European 3G auctions. Draft. Lucking-Reiley D. (2000). Vickrey auctions in practice: from nineteenth century philately to twenty-first century e-commerce. Journal of Economic Perspectives, 14(3), summer. Pp Lusht K.M. (1996). A comparison of prices brought by English auctions and private negotiations. Real Estate Economics, 24(4): pp Mayer, C.J. (1998), Assessing the performance of real estate auctions, Real Estate Economics, 26(1), pp Milgrom, Paul. Auctions and Bidding: A Primer. Journal of Economic Perspectives, 3(3), summer, Ong S.E, Lusht, K. & Mak C.Y. (2004). Factors influencing auction outcomes: bidder turnout, auction houses and market conditions. Unpublished manuscript. Walley M.J.C. & Fortin D.R (2004). Behavioral outcomes from online auctions: reserve price, reserve disclosure, and initial bidding influences in the decision process. Journal of Business Research (article in press). 14