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Analyzing Real Transactions: Game Theory

In our little world at, we often find ourselves being put into new, unusual, and at times uncertain, situations.  Most of them are related to real estate, to be certain: usually we find ourselves asking questions like:

Does this house make a good potential deal?

How can we structure a deal so our clients can make the most of their investments?

What is an appropriate exit strategy for this particular home?

Would this property be a good candidate for lease purchase?

And so on.

For the experienced investors reading this, such questions are very bread and butter queries that get asked hundreds of times a week if you are full – time real estate investors like we are.  You are always evaluating deals and opportunities, of course, and throwing away usually about 90% of what you find.  As readers should know by now, just because a house is for sale DOES NOT necessarily make it a good deal.

Naturally then, we run into situations in the world of wholesale real estate where the answers are uncertain – you can make the right move for the wrong reason, or conversely, the wrong move for all the right reasons.  And none of this is more true than when you are in the middle of a heated, multiple offer situation.  I’m talking about a multiple offer situation for a GOOD property, where victory means substantial money can be made and defeat translates into you watching someone else’s victory dance.  Not a good place to be, to be sure.

Because these situations tend to happen more often than we would like, the key then, is to maximize our ability to succeed in these situations, while minimizing being put in the position of losing the negotiation, and thus the deal.  The difficulty arises when you, as a real estate investor are told that you are in a multiple offer situation and the listing agent needs ‘highest and best’.

In this case, you have one of three choices:

1)     Your highest and best offer remains as your original offer – what you have submitted is your highest and best.

2)     You withdraw your offer.

3)     You offer a higher price, in the hopes of outbidding the competitors and winning the process, thus securing the investment.

While there are merits to the first two approaches, for the purpose of this discussion we will focus on how to best implement the third strategy, and in doing so increase your winning percentage when you are in multiple offer situations.

Game Theory

For the sake of this illustration, we need to draw upon the game of poker to see what constitutes making the right play.  In poker(Texas Hold ‘Em), each player is dealt two face down cards.  You, as a player, cannot see your opponent’s face down cards.  So in this way, Poker is a game of incomplete information. You have limited information with which you can make a good play.  But in Poker, your goal is not to make a ‘good’ play. You want to make what is, essentially, the optimal play – whatever that may be(checking, calling, or folding).

The problem then, was introduced by World Champion Poker Player Chris Ferguson a few years ago at a public address where he asked this question: if you were in a poker hand with an opponent, and you had made a decision as to what your play was going to be, BUT THEN HE ACCIDENTALLY SHOWED HIS CARDS TO YOU, would you play the hand differently?

Most inexperienced people would say “well yes, of course I would play the hand differently, because I know what he has.  I would pressure if my hand was stronger, and fold if my hand was weaker.”

This lack of experience, however, reveals to us that such a player was not making the ‘optimal play’.

You see, the optimal play is the best play a player can make REGARDLESS of what his opponent is holding.  It is not necessary to know the opponent’s hand to make the correct play.  What matters is that you valued the strength of your hand vs. your opponent’s perceived hands, and based on what you found using deductive reasoning you made a play that was the correct play, no matter what your opponent was holding.

Without getting into specific poker examples, let’s assume that there are optimal plays in real estate when you are involved in a multiway negotiation just as there are optimal plays in poker.

Knowing this, let me pose to you a real – life example that took place recently.

A guy I knew in the State of Tennessee, came to me with this problem:

‘I have a house that will appraise for 90k, and it is listed for 37k.  Doesn’t need too much work, but here is the problem – there are five other offers on the table besides, ours, for a total of six offers. The house is a great deal, but I am not sure what to bid to win the multi – offer negotiation.  If I bid too low, I’ll lose.  If I bid too high, then it is no longer a good deal and it is like every other offer I have thrown away because it isn’t strong enough to buy.  What should I do?’

Now, he had a very good point.  He wants to win, certainly, and does not want to lose the deal.  But what if he bids too high and wins?  Then he has unnecessarily overpaid for the home anyway, creating what is essentially a phyrric victory.  So, we once again, just as in poker, are faced with incomplete information.  However, let’s examine what we DO know:

In every multiple offer situation, especially where the house is a really good deal(I mean, why bid on terrible deals anyway?) there will be:

–        People who bid UNDER the list price, trying to get a ‘deal’

–        People who make a full price offer, thinking that they will ‘beat’ the other bids

–        People who will overbid the home, with the goal of ‘winning’ the bid.

There is a subcategory for this last one here, as follows:

–        People who bid over the list, knowing that it is worth it to pay more for the home based on it’s end value, post renovation

–        People who over bid just to ‘win’

So, based on this knowledge, we know that, because other people will probably overbid to win, we too have to bid over list price to get to the winner’s circle.

I discussed this with this guy, and he came back with this:

“I can over bid on the home, but what happens if local investor x comes in and bids 60k, just to win, and I bid 47k? Then I have lost anyway.”

While this is true, Game Theory tells us that really, it doesn’t matter what the OTHER investors are doing as long as you are making the optimal play.  In this case, I told the investor, the optimal play is this:  how much are you willing to pay for the home IF you knew that you could make the winning bid?  If you knew your highest bid would win, but you had to bid EXACTLY the most that you were willing to pay, but if you bid a dollar less, you would lose to a competitor, then you have to determine what you are willing to pay.  Game Theory dictates that, even in this non – poker situation, there is truly an optimal play to be made.  The point is, if you bid more than you are willing to pay, because you know that your highest and best price will win, bidding over your best price would be a waste of money.   So give it your highest and best, and if you get beat because someone bid higher than you, if you have done your due diligence correctly on the front end, THEN IT NO LONGER MATTERS IF YOU WON THE BID OR LOST THE BID SPECIFICALLY BECAUSE YOU MADE THE OPTIMAL PLAY.

Focusing on the optimal play is the ONLY thing that matters.  The line between what constitutes a good deal and marginal deal can be very thin, at best, and this is where exercising due diligence for ALL aspects of the investment helps you to make the correct decision.  You have, essentially, used your deductive reasoning to offer a price which makes a property a great deal if you get it – but if another investor beats you out, and you were unwilling to pay a dollar more than your highest and best, how could you possibly be upset about not winning the deal?

When you are transacting the volume we are at, we tend to get into lots of multiple offer situations each month.  We don’t get nervous about multiway bids, though – Game Theory dictates that we make the optimal play and NOT WORRY about what the competitors do.

Our winning percentage in these situations is pretty good, too.  So, the next time you get the call that you are in a multiple offer situation and you need to submit your ‘highest and best’, pause and consider what the truly optimal play is.  Make the optimal play, and you can have the peace of mind that you made the correct move, regardless of the end result.