How to avoid Auction Anguish: The Science of Auctions that led to a Nobel Prize

“Every day, auctions distribute astronomical values between buyers and sellers. This year’s Nobel Laureates, Paul Milgrom and Robert Wilson, have improved auction theory and invented new auction formats, benefitting sellers, buyers and taxpayers around the world.” - The Royal Swedish Academy of Sciences 

Astronomical values. How are these values traded on such a huge scale with such efficiency between people from all over the world? In Australia, we love Auctions, particularly in Melbourne, the ‘Auction Capital of the World.’ Well, it turns out that two American scientists, Paul Milgrom and Robert Wilson, might just love Auctions more than anyone in Melbourne. Robert alone has been studying them for over 50 years. 

It is no surprise then, that after all his hard work and dedication, that he has been awarded the Nobel Prize in Economics this year (or, more accurately, The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2020). Without getting caught in the weeds, in the vast amount of research and work that has been done in Auction Theory, we wanted to take a look at this prize, what it means for Auctions and what it means for you if you are in the property market. While new Auction Methods have been created by this research, they are more complex than we would need to buy or sell properties (for example, they found new ways to distribute complex public assets, such as frequency bands, electricity and natural resources). What is really interesting to us, is that Auctions are so well-studied, we know what the research tells us and can apply it to everyday situations. So, what can we teach you about Auctions and Game Theory from a couple of Nobel Prize-winning Economists?

First, we need to start with why we use Auctions at all. Why do we need to gather outside a house (or online) and bid against each-other and find a winner, can’t we just make offers and be done with it? Well, Auctions perform two really important functions:

1.       Buyer Selection: They provide a transparent environment to select the ultimate Buyer

2.       Price Discovery: They help us to discover the specific Price of exchange

While Auctions may not seem exciting to some buyers, they are actually an incredibly useful tool for people looking for a home. They can provide you with information about other buyers and what they have valued the property at, and they allow you to see who is genuinely interested – two huge advantages. The other benefit of Auctions is you never need to pay a price higher than your budget, and you don’t even need to spend all of your money. All you need to do is bid a small amount more than the second highest bidder. Instead of making an offer far above anyone else’s – you get to buy it for just slightly more than the underbidder. Here is what the research suggests effects the outcome of an Auction, so you can make the best decision on Game Day.

The outcome of an auction depends on three things:

1.       The Rules and Format of the Auction

The Auction Method most common in Australia is technically called a “First-Price Open English Auction.” All this means is that the last bidder pays their highest bid (the ‘First Price’), that you know what the other bidders are bidding (‘Open’) and that the bidding starts at a low price, or zero and moves in the upwards direction (that is the ‘English’ bit). Other methods have different rules, like a Dutch Auction: where the bidding starts above the marketed price and is lowered by the auctioneer slowly, until a bidder claims the item at the price they are happy to pay.

2.       The Attributes of the Object being Auctioned off

Some things are easy to price, like a mobile phone - where millions of the exact same object are sold every day. Other things, like Property, is hard to price; it is scarce, rarely transacted and, within reason, no two of them are the same. Different properties are also easier or more difficult to price. For example, apartments in high-rise buildings where a lot are bought and sold all the time are far easier to price than a fully-renovated luxury period home which is one-of-a-kind. The important thing to note here is that people value things at different prices, and Auctions help us sort out who values it the most.

3.       Uncertainty

It turns out uncertainty and risk are critical to the final result – and are the enemies of high price. The research shows that the more information a buyer has, the more confident they are in paying a higher price. Equally, if there are a lot of ‘unknowns,’ there is inherent risk in paying more. Auctions can help remove some of this uncertainty as buyers get to see other people interested, who also have information about the property and the price it is worth to them.

As always, more information and professional advice is the key. If you have time, do your own thorough due diligence and do it properly. Research the area, the properties available, the sale prices, the market and what drives other buyers and their purchasing decisions. Future-Proof your property purchase by knowing the market well, really well. Or, find someone your trust that can guide you through this, because while Auctions are amazing tools for the transfer of value, you don’t want to get caught paying too much.

How can you avoid mistakes when buying?

Everyone attending Auctions hopes for an edge, but rarely do people want to invest the time and effort to actually create one. The best edge you can discover for yourself is an Informational Advantage. This might be information about the Property, the Owner, the Agent or the Other Buyers that are interested. You might know about the neighbours, the area or the prices paid for similar properties better than anyone else. This reduces uncertainty, and apart from making the process feel far easier and more worthwhile – it also gives you that edge. Instead of worrying for weeks and weeks about what a property might be worth and what you should be willing to pay for it, get a professional to prepare a report for you, or even have a Valuation conducted by a Certified Practising Valuer (CPV). While expensive to conduct if you do it on every property, this will give you the ultimate confidence in pursuing the home of your dreams. The interesting thing about valuations is the definition of value: “One unwilling buyer.” That is essentially what the definition of a property valuation boils down to (the complete definition is below). I have seen buyers make mistakes time and time again, and the most common reason is that they didn’t have enough information. The second most common mistake stems from a lack of time; without the time to inspect properties thoroughly, conduct a proper due diligence and settle in for a rewarding negotiation, some people just pull the trigger and purchase. Property purchases can set you up for life, but they can also cripple you financially for years if mistakes are made.

Here are three tips to avoiding the worst mistakes made when buying:

1.       Research First: Don’t dive into buy something without checking the depth of the pool first

2.       Money: Know your financials & how the system works - if you don’t, find someone that does

3.       Time: If you don’t have time to do your due diligence properly, find someone who can

For those that are interested, the definition of value in Australia stems from the legal case Spencer v. The Commonwealth of Australia (1907) and reads:

What would a man or woman desiring to buy the land have had to pay for it on that day to a vendor willing to sell it for a fair price but not desirous to sell?

So what? Well, if you really want to buy a house and absolutely love it, the reality is that you are not one “unwilling” buyer, you are desirous. You are competing in an environment with other, very much willing, buyers. Therefore, paying more than a valuation isn’t necessarily the end of the world, what it actually means you know what price ‘the market’ will be willing to pay for it at that point in time, if you needed to sell it. This reduces risk, but doesn’t mean you paid too much. In order to buy a quality investment property or your dream home, the reality is that you will need to pay more than anyone else for it – and that’s ok.

The etymology of the word Auction could be ironic, it comes for the Latin word Augere, meaning to increase. Many people think that Auctions create a competitive environment which inevitably leads to people paying a price that is too high. Some buyers even avoid Auctions entirely. While we understand their trepidation, reducing the opportunities you have to buy a property even further by not engaging in the Auction process isn’t a winning strategy. A winning strategy is to ensure you do your research, pound the pavement to inspect as many properties as possible and ensure you have the right advisors to guide you through buying a property.  While the root of the word Auction may mean increase, it doesn’t mean just an increase in the price, it can also be an increase in opportunities.

Auctions can feel risky, especially given most buyers may only attend a handful in their lifetime, and bid at even fewer. Real Estate Agents, Auctioneers and other Property Professionals literally do it for a living (no wonder it can be intimidating). We have seen how some buyers stretch their budgets during an Auction, we have seen people buy properties at incredibly low prices at Auctions and we have seen people miss out on properties because they just didn’t want to go to an Auction at all. We have seen it all, and we just hope we can help as many people as possible make their dreams a reality. The best way to buy well is to reduce uncertainty, and the best way to reduce uncertainty is to educate yourself. When you go in to compete for a property against other buyers, property professionals and Real Estate Agents who do it full-time, it might be worth evening the playing field. Do the research and find an advisor you trust, it could save you thousands of dollars and an invaluable amount of time.