Real estate negotiation: establishing value
How much is a property worth? Is it whatever two parties agree to? Is value established by recent nearby comparable sales?
Negotiating the sale of residential real estate is no more difficult that negotiating for any other product of service that doesn’t have a fixed price; however, due to the colossal cost of houses, the process is more important financially than negotiating for other big-ticket items like automobiles. A mistake made while buying or selling a house could cost as much as a new car; sometimes such mistakes could pay for many cars. Skilled negotiators can obtain favorable pricing and terms without the assistance of a broker, but the novice who is inexperienced at this process often will not. Novice negotiators can benefit from using a professional real estate agent.
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 everyone. The one goal both parties share 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. The seller would also try to introduce other factors so as to make the property look more worthy. For instance, they’d say that the house already comes with the best hepa air purifier for cat or dog hair and dander, and there are high chances that pet owners will be lulled into the offer.
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.