Dollar auction
Why some games make no sense to play
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Professor Max Bazerman started his MBA class at Harvard Business school every year with a game: He held up a $20 bill and asked his students to bid for it. They could bid any amount and raise their bid in $1 increments. If they bought the bill for less than $20, they would profit from the difference. But there was a catch. The person who came second also had to pay what they bid without getting anything in return.
The game started out normally, with people bidding $1, $2, $4, and so on till it started slowing down at about $12. At that point, most people dropped out of the game as the second-highest bidder would lose more than $12 for nothing. Soon, there were only two people left, A and B, out-bidding each other. The turning point was when B bid $19 and A bid $20. If B gave up at this point, he would have lost $19. But B bid $21 – more than the bill was worth – so that he would lose $1 rather than $19. In turn A bet $22, and the game continued. Sometimes the bids stopped at $50, $100, or beyond. The record bid was $204, more than ten times what the bill was worth!
Winning an auction like this is a pyrrhic victory – you lose more than you have gained. The dollar-auction has produced such pyrrhic victories reliably over many years because human nature hasn’t changed. When the auction begins, the bidding is for the possibility of gain. But at the turning point, the goal becomes to avoid loss. The bidders are emotionally invested in the process, and they don’t want to lose face, so the bids keep escalating far beyond the point of sensibility! This is an example of the sunk cost fallacy, and though it’s entertaining in a classroom, it can turn deadly in case of an arms race between countries or bankrupt companies that throw bad money after good money.
A situation that’s more relevant to you as an investor is when you buy a house.
How not to buy a house
Buying a house is an emotional decision, and you might be neck-deep in negotiations before you realize that the deal makes no sense. What is the strategy to win this sort of game? Well, the best solution is to decide when to stop before you start. It’s important to set this limit beforehand as emotions will get the better of you after starting.
This is all the more important in 2023 because now is not a good time to buy a house. Mortgage rates are high, Fed rate hikes are imminent, national housing prices might drop further and rents saw their largest decline in 7 years.
If you still believe in making a long-term investment, you need to have a clear understanding of the financial and emotional costs to set a price range for yourself that you will not cross. Based on my experience in the real-estate business since 2008, let me tell you about the four factors you need to consider before starting negotiations.
Do not overpay
In real estate, there’s a saying: “You make your money when you buy, not when you sell.” That’s why it’s crucial to not overpay. It’s understandable if it’s a once-in-a-lifetime “Forever Home”, but for almost everyone else, that house that you think is perfect is in fact replaceable. If it’s replaceable for you, it’s replaceable for buyers in the future as well. But the good news is that it gives you the room to negotiate!
The first rule of negotiation is that you must be prepared to walk away from the deal. Unfortunately, new (and even seasoned) homebuyers get terribly excited about purchasing a property and so emotionally invested in it that all logic goes out the window. If the seller knows you will buy, you lose any leverage that you might have. As I said, you make money when you buy, and only when you buy at the right price.
There are deals out there where you can instantly buy an undervalued property for 5-15% less than they’re worth, but to catch them:
You need to be patient
You need to know what the benchmark price is
So understand what homes are recently selling for, set a maximum limit before you start looking, be aggressive with your inspections – and stick to the plan. Remember it’s your money!
Run the numbers
It’s one thing to know what the right price for a home is, and it’s another to know what the real price is. By that, I don’t mean figuring out that the mortgage is $2,500 for a $400k house. The real costs of buying a house are the ones that are hidden and accumulate over the next 5 to 7 years. If you underestimate the amount you will pay for repairs, maintenance, home insurance, landscaping, utilities, and property taxes while you overestimate the amount you will receive in rent, then you have a problem.
This isn’t a problem restricted to real-estate investors. Homeowners are equally likely to walk into a house and close it without due inspection, only for things to break as soon as they move in. The better alternative would be to to just rent a home for a fraction of the cost while waiting for a better deal – patience pays off!
The final point regarding costs to keep in mind is to prepare for a budget overrun. Having sold over $130 Million worth of homes over 15 years, I can tell you with certainty that you will overshoot your budget on every single repair. This isn’t a mark on the reliability of your contractor. It’s just that planning is incredibly difficult because we have an optimism bias.
So for every renovation, assuming you’ll spend 25% more than you intend to is a good rule of thumb. What I do is to always keep 3-4 months of expense + 25% in a separate checking account for each property that I own. Once it exceeds a limit, I invest the excess amount. After you have an estimate on how much your house is likely to cost, it’s time to think about how to finance it.
Minimize debt
Don’t get me wrong. Debt can be an incredibly powerful tool to lock in the price of an asset and turn inflation to your advantage (more on that here). But taking on too much debt is a mistake if it needs multiple factors to align for it to pay off – If you are expecting rental income to be stable and the real estate market to stay strong and the job market to sustain your payments for your plan to work, then even one factor failing can throw a spanner in the works.
If you take on too much leverage, your mortgage payments will also be significantly higher. Unless you have the savings to act as a buffer in the event of a prolonged vacancy or loss of income, the debt can turn into financial stress really quickly due to factors completely outside your control. This is what happened in 2008. The solution is to save up for at least a 20-25% down payment for anything you purchase so that you have the wiggle room and equity to pull from.
For the remaining portion of your loan, you should always prefer a fixed-rate mortgage to an adjustable-rate mortgage unless you really know what you’re doing. Adjustable rates might seem attractive in the short term compared to fixed rates, but they are susceptible to increasing due to interest rate hikes. Your income might not be able to adapt as fast as the payments increase. On the other hand, locking in a fixed-rate mortgage for 10 to 30 years lets you plan well in advance and prevent any unpleasant surprises.
As you get more experienced, maybe you can refinance for a cheaper rate or pocket more money by taking an adjustable-rate mortgage for 5-7 years. But especially in this climate, I’d recommend sticking with the safe option.
Don’t be short-sighted
One thing I repeat all the time is to only buy a house if you plan to hold it for 5-7 years. That’s not just because it takes time for home values to appreciate – Forbes found that it takes 5-7 years on average to break even on a property purchase, because of the costs of buying, owning, and selling.
If you buy a house for $300k, it can take up to $6,000 in escrow charges to close the deal and $3,000 every year for maintenance, taxes, and a bunch of other payments. After 5 years, you would need to sell the property for $340k – A 13% increase – just to break even after taking commissions and closing costs into account. Housing generally goes up, but it’s in no way guaranteed, which is why having a longer time-frame helps your chances of turning a profit.
Those are all the pointers you need in place before you start working on a property deal – remember, once you’re in the heat of negotiation, it’s difficult to set ground rules for yourself. Before I wrap up, let me give you a bonus tip if you plan on renting out your property. Don’t optimize for the rental amount, optimize for the quality of the tenant.
Back in 2012, I made my first mistake when I was desperate for money and had sunk everything into renovations. Ignoring all red flags, I rented out to the tenant who offered the most – and he promptly stopped paying within six months. By the time I managed to evict him, he had trashed up the place. The 4 months of lost rent, $8,000 in damages and thousands in eviction fees wiped out all profits that year. Nowadays I take my time to pick a tenant because I understand it’s a long-term relationship and the perceived losses from letting your house vacant for a few months will be compensated for by a tenant who may pay lesser but maintain your house well.
If you follow these guidelines, and focus on the long-term, I truly believe you’ll be in a much better position as a long-term investor and on track to make money.
What are your experiences with negotiating a property in this climate? What do you think of the guidelines, and would you add any of your own? Let me know in the comments!
Stay safe, stay invested and I will see you next week – Graham Stephan.
A lot of effort and research went into making this article, so if you found it insightful, please help me out by clicking the like button and sharing this article.
Quick story. My wife and I were in Vegas. We decided play slots for fun. We set parameters of when our 200$ was gone so we’re we. If we got up to 100$ we were also done. On the last pull ( down 200$) we won 300$ hitting our cap. The casino guy was shocked when we walked away and cashed out! Rules are important as you note.
Great article as always! I'm currently trying to convince my friend not to buy a Condo in Chicago due to him having a 3 year plan to move out - so I am going to share this article with him. Thanks.