Wednesday, May 23, 2012

Real-Estate Agents

Should you use a real-estate agent to help buy or sell your home?  You'd be forgiven for thinking that the answer is a clear, "No."  No-agent websites have proliferated, and keeping an extra 3% on your house (the typical 6% commission is divided between buyer's and seller's agents) has some obvious appeal.  This post looks at the theoretical and practical issues of using a broker (many of which apply to using agents in other negotiations as well).

Some academics have argued that the housing market suffers a pretty serious level of "agency cost," i.e. your agent may be getting you a worse result because your interests are unaligned.  Consider this passage from Freakonomics:
A real-estate agent may see you not so much as an ally but as a mark...[A study found] that an agent keeps her own house on the market an average ten extra days, waiting for a better offer, and sells it for over 3 percent more than your house -- or $10,000 on the sale of a $300,000 house...The problem is that the agent only stands to personally gain an additional $150 by selling your house for $10,000 more, which isn't much reward for a lot of extra work.  So her job is to convince you that a $300,000 offer is in fact a very good offer, even a generous one, and that only a fool would refuse it.
Let's get to the heart of Levitt's point about incentives.  Your agent is getting a good commission, so she has a strong incentive to sell your house, but she doesn't have as good an incentive to sell your house for the highest price.  The commission structure rewards her for closing the deal as quickly and simply as possible, whereas you might be willing to wait or take some risk in order to get a higher price.

Here's how it generally works.  Your agent splits the 6% commission with the buyer's agent and then splits the remainder with his or her brokerage firm, so the actual commission is more like 1.5%.  1.5% on a $300,000 house is $4,500 which is a pretty good commission for one transaction, but the incremental return on boosting the sale price is much less.  For every dollar she adds to the sale price of the house she keeps just one and a half cents.

Let's take a specific example and see how this might play out.  Suppose you're interested in moving to a larger house within your neighborhood.  You're not in a hurry, but you're ready to move -- perhaps you and your spouse have decided to have kids and you want to add a couple of bedrooms and a yard.  Your current house has a market value somewhere in the range of $450K to $550K and after exploring your purchase options (and taking into account your existing mortgage) you conclude that your BATNA (staying in your current house) is preferable to any sale price that earns you less than $460K (after commission).  Here's what that implies for the value created by selling your house, for you and for your broker:

Sale Price
Value to You
Value to Broker

If we compare sale prices of $450K and $550K we see a huge difference for you -- from unacceptable to nearly $60,000 better than your BATNA.  The broker's commission changes much less -- at the unacceptable price it's 82% of what it is at the home run price.

This can work against you in two ways.  First, the broker has only modest incentive to do extra work (trying to find a better buyer).  Let's say you've got an offer for $500K but if the broker were to really work her network and invest another twenty hours of work she could find a buyer at $550K.  That's an hourly return to you of over $2,000 but for her it's less than $50 per hour.  She's likely better off spending that time cultivating new clients since the bulk of her commission comes from getting a sale at all rather than from maximizing price.

The second potential problem is risk aversion.  Intuitively it might seem that you're more risk averse, since it's your home, but in many cases the reverse is true.  Let's again consider our $500K buyer.  Suppose we think there's a 75% chance we can get that buyer to pay $550K if we hold out, but a 25% chance that we'll lose the sale.  In this situation, that's a very good bet for you.  You have a 75% chance of gaining $47,000 in value and a 25% chance of losing $20,000 in value.  For the agent it's a bad bet.  She has the same chance of gaining, but her gain ($1,250) is much lower than what she's risking ($7,500) so her expected return is negative.

This means that the agent has an incentive to encourage you to price your house at a lower-than-optimal (for you) price and to be less aggressive in negotiating.  If you have an offer for $500,000 (which is better than your BATNA, but not much), your broker may tell you that that's the best offer you're likely to get and you should take it.

Levitt argues that there's a straightforward and obvious cost to all this -- brokers push you towards a lower price in order to close the deal, while when it's their own house they hold out and get more money.  Does this mean that hiring a broker is a bad idea?

Not necessarily.  First of all, all of Levitt's "evidence" other than one study is anecdotal...and the plural of anecdote isn't data.  As for the study itself, while it does control for factors such as "location, age and quality of the house, aesthetics, and so on" there are two rather obvious factors it did not take into account: motivation for selling and where the seller was moving.

Opportunistic sellers are by nature more patient and more likely to respond to price opportunities than someone who has to sell.  Someone who has already bought a house or who is moving for a new job faces time pressure that may prevent them from holding out for a higher price.  Brokers, being immersed in housing, are presumably more likely to sell opportunistically (e.g. when the market is particularly hot for the type of property they own, or because a colleague with a suitable client is more aware of an agent's house than a random property on the market).  Since real-estate brokers tend to nurture community relationships over a long period of time it may also be that they are more likely to upgrade locally than move to another region, which again would let them choose their timing more patiently.  Thus, the differences Levitt notes could be explainable by factors he was unable to control for.

The reality is probably something not quite as bad as Levitt suggests, but still raises the question of whether hiring a broker is a good idea given that your incentives may be mismatched.  For most of us I believe the answer is still yes.  A broker's expertise is very useful in navigating the process of buying or selling a house and reducing the risk of pitfalls.  If you're selling, a broker can advise you on how to present your house most effectively, how to respond to buyer conditions and be alert to major pitfalls that could result in legal liability.  She may also be able to interpret statements from buyer's brokers more accurately than you would, since they know each other's signals, making her a useful partner even if you want to take the lead in negotiations yourself.

The more interesting question for me is how you might address the mismatch of incentives to get the best use of your broker.  A lot of sellers are negotiating with their broker but I suspect they're doing so in the wrong way.  The typical approach is to push for a lower commission.  This saves money but worsens the incentive mismatch and essentially relegates the broker to the role of low-skill intermediary whose only value-add is likely to be handling the legal paperwork.  If Levitt is right that broker effort adds to the final selling price then the last thing we want to do is remove that effort.

In many situations a more effective approach would be to suggest a higher commission rate but based off of a floor.  Suppose in our example above the seller's agent received a 30% commission (apart from the 3% that goes to the buyer's agent) on the purchase price less $450,000?  In other words, if the price is $450,000 (which you can presumably get without an agent's help) the agent would get nothing but would get twenty-five cents for each additional dollar?  Now a $450,000 price is worthless, a $500,000 price nets her $7,500 and a $550,000 price yields $15,000.  That extra twenty hours of work would now pay almost $400/hr, making the effort worth her while.  (These numbers are used only to illustrate the point; the general idea would be to set a floor that was easily achievable and a rate that would make the broker's commission equal at a 'normal' sale price.)

A side benefit to this approach is self-selection.  An agent who is confident she can get the highest price for your property is more likely to accept a commission structure like this, whereas one who thinks they're unlikely to do better than $500K may balk.

Finally, don't forget the power of talking.  Even if you decide you don't want to negotiate an unusual commission structure, talk to your agent about the incentive problem.  If you're comfortable holding out for a higher price make sure that your agent knows this and that she thinks of her mission to get you as high a price as possible rather than just completing the sale.

Tuesday, May 22, 2012

The Brinkmanship Trap

We're witnessing two new examples of brinkmanship in world politics.  In Europe, Greece (both its newly-elected government and its voters) is in a showdown with Germany and much of the rest of Europe over the austerity plan agreed as part of the Greece's bailout.  In May, Greek voters shifted dramatically against the incumbent parties that had agreed to the austerity package in favor of parties that opposed it.  With no coalition government proving possible, Greece is headed into another set of elections in June with the very real prospect that Greece will shift further against austerity, putting the rescue package and indeed Greece's ability to remain in the Euro at risk.

At home, meanwhile, Republicans and Democrats are rattling sabers over the debt ceiling again.  We may be headed for a repeat of our recent showdown, in which Republicans stake out an extremely aggressive position and threaten to bring about default if their demands aren't met.

What is brinkmanship?

I define brinkmanship as a tactic in which one or more parties stakes out a position that, if granted, would capture far more of the ZOPA than might be expected from normal negotiation and then attempts to a real or perceived commitment to that position, such that the other parties think that failing to grant it may mean no deal is possible.

Commitment is a critical component.  If you and I are dividing $1,000,000 in a situation where we both go home empty-handed if no deal is reached, a "demand" by me that I get $900,000 is something you'd probably laugh off as an aggressive opening.  You know that you can hold firm at a much better split and that it would be irrational for me not to move.

But what if I show you a contract that compels me to pay $2,000,000 to a third party in the event that I agree to accept less than $900,000?  Now I'm committed to my position and the math has shifted against you.  Beforehand you could say, "Sorry, Chad, but I'm not going to be taken advantage of.  We can split the money evenly or we can walk away."  You'd be presenting me with a choice of $500,000 or nothing. Now, however, you're offering me a choice of negative $1,500,000 or nothing because if I accept your deal I lose far more on the contract.  It's irrational of me to take any deal less than $900,000 and thus you're the one who has to choose whether to take $100,000 or nothing.

Commitment can take many forms.  Public statements that would be embarrassing to step back from, contractual commitments or steps to make it literally impossible to step back all serve the same basic purpose of blotting out a large chunk of the ZOPA so that the other party(ies) must accept a deal they would normally balk at.

What's wrong with brinkmanship?

As we saw above, effective brinksmanship can be very rewarding.  So what's wrong with it?  Why shouldn't every rational negotiator consider brinkmanship merely another available tool, like making multiple offers or adding parties to a negotiation or anchoring?

The most obvious problem is that brinksmanship is extremely damaging to relationships.  It's essentially an effort to use force and intimidation to capture more than one's fair share of the pie -- and since it's out in the open there's no way to soften the effects.

Beyond that, brinkmanship can lead to no deal at all, even when the ZOPA is large.  There are two principal reasons for this.

First, brinksmanship is rarely clean.  My contract in the example above would be clean brinksmanship.  One moment we are negotiating on equal terms over how to split $1,000,000.  The next you can see that any deal that gives me less than $900,000 is impossible for me to accept.  In the real world, brinksmanship involves only partial commitments.  When Boehner declares publicly that he won't accept any revenue increases as part of a debt ceiling deal he's making it harder to accept them but certainly not impossible.  Many commitment gambits carry a risk that they'll be viewed as bluff and bluster by the other side.

Second, the incentive to engage in brinksmanship is generally mutual and can be mutually reinforcing.  If, in fact, the ZOPA is genuinely large that means that both sides have a lot to lose if no deal happens.  Remember, the ZOPA can be thought of as the total amount of money sitting on a table waiting to be divided.  Brinksmanship can be self-reinforcing because our rational side often takes a back seat to our emotions if we think someone is treating us unfairly or trying to push us around.  Since brinksmanship is pretty much explicitly unfair and bullying as a tactic, our natural response to it is to push back just as hard.

Thus, while brinksmanship seems like a sensible tactic in a lot of game theory scenarios it is highly problematic (at best) in most real world situations.  Moreover, it is almost never a good thing to be on the receiving end of.  This brings us to our final question.

How can we prevent our counterparts from employing brinkmanship against us?

The key to fighting brinksmanship is to remember the ingredients that make it attractive:

  1. Large ZOPA, relative to value creation opportunities
  2. Rational expectation that brinksmanship may lead to capturing the lion's share of the ZOPA
Both of these can be fought.  Let's start with the ZOPA.  A large ZOPA is a good thing but sometimes a ZOPA is big because both sides have a terrible BATNA rather than because the deal is wonderful.  A strong BATNA makes you less vulnerable to brinksmanship (and a number of other strong-arm tactics), which is another reason why you should never think of your BATNA as fixed.

It's also important that brinksmanship (because it tends to shut down value creation efforts) depends on a ZOPA that's large relative to value creation opportunities.  You can't always ensure that every deal you do has value creation but you can often influence deals in this direction.  Moreover, you can improve the chance that your counterpart is aware of value creation possibilities by raising them up-front, e.g. by including multiple options in your initial proposal.

Next, you can attack the "rational expectation" problem.  The simplest way to do this is not to give in to brinksmanship and to let other parties know that you haven't.  I like sharing stories of times people have attempted strong-arm tactics against me in part because they're often good learning examples but also because it reminds people that while I'm a sweetheart of a guy who loves to share information and to create value I'm not a pushover.

Similarly, if you are facing brinksmanship now you want to send a clear signal that you're not going to give in to it and also consider building a bridge that will let the other party pull back.  This can include suggesting a shared principle by which the disagreement could be settled or a third-party whose opinion could be sought.  Brinksmanship is a gambit in which the aggressive party traps him or herself in the hopes that doing so will force you to give in.  If you're not going to give in (and most often you shouldn't) then it may be that the only way to save the deal is for you to help the person out of their trap.

Tuesday, May 15, 2012

The Mancini Coalition

One of my formative moments as a negotiator took place almost fifteen years ago during a case exercise at  Harvard.  I had been assigned the role of Enviromental Lobby in a multi-party negotiation over how an economic region would be developed.  Other roles included organized labor, the state's governor, business interests and a fifth party representing general voters.  As with many such exercises, the range of agreements was abstracted into several different issues, each of which could be given a score from 1 to 5. An agreement didn't have to be unanimous but required any four of the five parties.

As I read through the case, finding a good strategy looked difficult.  My goal (as defined by the case) was to get the highest possible score for environmental regulation but no other party seemed likely to have that high on their list of priorities.  (The case specified that the Governor had run on a "jobs" campaign.)  My best chance was to form a coalition with another party but I worried that it would be relatively tempting for the other four parties to shut me out and either form an agreement without me or present me with an ultimatum of agreeing to support a bad environmental result or having them go ahead with a worse one.

I arrived early at the designated negotiation spot without a solid strategy.  I hoped I could feel out other parties and find a favorable surprise -- perhaps the Governor really wanted a unanimous decision and could be persuaded to apply some pressure to the other parties.

Then Walter Mancini arrived.

Walter is one of those people who embodies the best traits of the military.  He's confident but humble, always ready to lead or to follow as the situation warrants, and completely trustworthy.  It turned out that he was playing organized labor and that, like me, he had one metric that was by far the most important to him.  He had a mild preference for low environmental regulation but it wasn't critical.

I proposed a coalition.  He and I would tell the other parties that we would agree to any deal that scored a 4 out of 5 on each of our primary metrics but would refuse any deal that was below 4 on either.  Walter agreed.

When the rest of the parties arrived, we explained our agreement.  Predictably, the other three parties tried to break our coalition, mainly by offering Walter more favorable deals.  Predictably, they failed.  In the end the three remaining parties negotiated separately to reach a deal that met our requirements.

Ever since then I've been a student of coalitions.  In my experience, negotiators often fail to get good value out of coalitions, either missing opportunities to build them, failing to nurture them or using them poorly.  I offer the following as a set of guidelines for building and using coalitions effectively.

  1. Think broadly about potential coalition partners.  Many people look only for parties with common interests -- our natural coalition partners.  Many times, however, your ideal coalition partners don't share your interests.  Walter was an ideal partner even though our interests were somewhat at odds because we trusted each other.  Knowing the other wouldn't defect made it easy for us to turn down favorable deals with confidence that we wouldn't get punished for it.
  2. Think about the purpose of your coalition.  Coalitions frequently exist to increase the power of their members but that's not the only function they can serve.  Some of the most effective coalitions are designed to persuade rather than to exert power.  Bringing on board someone your counterpart trusts and thinks highly of may convince them to take your proposal more seriously or to give credence to your claims where otherwise they might be skeptical.
  3. Consider how other parties may react to your coalition.  If your coalition gives you a position of power you risk having the other parties feel threatened or that you're not negotiating in good faith.  More broadly, inviting the wrong ally into a coalition may push others away.  A classic example is the Bush coalition in the first Gulf War.  Israel was kept out of the alliance of nations that pushed Iraq out of Kuwait precisely because their inclusion would have forced other Arab states to exit.  Being aware of office politics can let you avoid a similar trap, where a seemingly-powerful addition to your coalition causes other key parties to balk.
  4. If your coalition is powerful, consider moderating your requests.  One of the most dangerous situations for negotiators is when they have the other party over a barrel.  It can be very tempting to use your power to the utmost and to extract every ounce of value but often this is not the best approach.  First, there is always a risk that the other party will reject your strong-arm tactics, either out of principle, out of anger or because you have misjudged how costly it is for them to say "no deal".  Second, such tactics can seriously damage relationships and become part of your reputation.
In our case, Walter and I diffused potential tension by asking "only" for scores of 4 out of 5 in our preferred metrics and in stating our willingness to agree to any deal that met that condition.  This was clearly a good result for us but not excessive.  Instead of being angry our counterparts respected our tactical move.  We got better outcomes than we might have working independently and we strengthened our reputations going forward, being seen as trustworthy partners and as strong but reasonable opponents.

Monday, May 7, 2012

Recognizing Weakness from Inconsistency

One of the most common ways people give away deception is through inconsistent behavior.  A recent case I mediated is a perfect illustration.  The two parties were very far apart.  The plaintiffs were willing to settle for a bit less than their full suit but not much.  They thought they had a winning case; on top of that they were emotionally invested, having (in their view) been treated quite unfairly.  The defendant's position was that they were wasting their time.  He'd declared bankruptcy subsequent to the debt being incurred and in addition he had a counter-claim against them for substantial damages.

By all appearances, it looked like a deal with no ZOPA, since each party thought their BATNA (going to court) was far better than what the other party might agree to.  During a private meeting my co-mediator in the case expressed extreme skepticism that any deal would be reached, and the court liason (a highly-experienced mediator) said afterwards that she didn't expect an agreement either.  I was almost certain that they would settle.  Why?  Poker experience.

It had come up during private session that the defendant had offered to pay nearly half of what the plaintiffs were suing for.  Normally this might be a "final offer" at his reservation value as a last chance to avoid going to court but what struck me about it was that it was wholly inconsistent with his stated beliefs.  If he indeed thought that bankruptcy protected him from the debt or that his counter-claim was likely to have the court award him money then why offer to pay half?  He wouldn't.  Either he was extremely risk-averse or he was bluffing.

Poker players are familiar with this form of bluff.  The last card comes up in a game of Hold-'em and someone bets big.  An experienced player calls because the bettor's play in prior rounds is inconsistent with a hand that would have benefitted from that card.  Perhaps their early betting suggested a high pair or AK and they bet big on a 4 that created no straight or flush possibilities. The trick is looking at a party's behavior as a set rather than in isolated pieces.  If some of that behavior is inconsistent with other words or actions it's likely that he or she is misrepresenting something (or, more charitably, is confused about their own interests).  That contradiction is often a point well worth analyzing closely.  After all, if someone is trying to conceal information from you it is likely to be information that you want to be aware of!

Almost every negotiation book discusses the importance of stepping back mentally during moments of stress.  William Ury coined the phrase "going to the balcony" to describe the mental exercise of imagining that the negotiation is taking place on a stage and then removing yourself to the balcony to look down on it calmly and objectively.  While it's certainly true that you should do this whenever your emotions are taking over it's just as important to do so whenever something your counterpart says strikes you as off.  A contradiction between what a person says and their previous statements (or known facts) often signals a chance for you to gain important information.  Make sure you take the time to reflect on those signals and to make the best inference as to what they mean.

(As it happened, the defendant did offer to settle for what the plaintiffs were asking.)