Some interesting info on the Stockholm Real Estate Market. Gives a good insight into how auctions can be used to assess attractive properties.

1. AUCTIONS IN THE REAL ESTATE MARKET – A REVIEW
Samuel Azasu
Building & Real Estate Economics
KTH – Stockholm
February 2006
______________________________________________________________________________________
Working Paper No. 55
Section for Building and Real Estate Economics
Department of Real Estate and Construction Management
School of Architecture and the Built Environment
Royal Institute of Technology

2. 2
EXECUTIVE SUMMARY
Auctions have grown in importance as a way of trading not only in art and antiques,
but also a wide range of goods including offshore oil and telecommunication
licenses, real estate, procurement contracts and even simple consumer goods. This
paper briefly reviews the basic auction types, and bidder behavior under the
various auction types. It further explores the relationship between the auction
types and the important properties that a good auction must have. Four basic types
of auctions are used depending on the good and the objectives of the auctioneer:
English, Dutch, first and second-price sealed bid auctions.
An important inference from previous research on auctions is that good or bad
auctions arise from two design issues: how to attract bidders and avoid collusion.
Auctions are used in the real estate markets across the world even if they are not
that widespread. Compared to private negotiations, real estate auctions have been
shown to result in higher prices for similar houses in good condition, and in
favorable locations. It could arguably thus support a vibrant housing market by
creating the right incentives for property to change hands. However, in declining
markets, and for distressed properties and/or for dissimilar properties, the reverse
could happen. The current Swedish ascending auction may be vulnerable to
collusion and consequently deter bidders. The solution may be to explore design
refinements rather than abolish auctions altogether. The paper also reviews
research on online auctions. The paper concludes by identifying issues for further
research.

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Table of contents
1. Introduction and definitions ................................................................... 4
2. Auction theory.......................................................................................... 5
2.1 Optimal bidding behavior ................................................................................. 5
2.2 Do institutional details matter? .......................................................................... 6
3. Auctions in practice................................................................................ 7
3.1 Auctions in general ......................................................................................... 7
3.2 Auctions in the real estate market ...................................................................... 8
3.3 Auctions in the real estate market in Sweden........................................................10
3.4 Factors affecting successful auctions in real estate.................................................10
3.5 ICT and online auctions...................................................................................11
4 Conclusion..................................................................................................12
References....................................................................................................14

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1. Introduction and definitions
Auctions are relatively recent phenomena as a ‘normal’ way of trading real estate.
However, their importance and role in trade in other assets have been around for
some time. Research into auctions has grown, underlying its importance as a
market mechanism. This paper briefly reviews the role of auctions in the real
estate market. It will explore the question of whether auctions are preferable to
sales by private negotiations. It will also identify factors that will determine
successful auctions from the seller’s perspective. The central argument, from a
review of the relevant literature, is that good or bad auctions are a matter of
design (Klemperer, 2002).
Baye (2003) defines an auction as an arrangement by means of which potential
buyers/sellers compete for the right to buy/sell a good/service. Actions can be
modelled as games, which means the auctioneer and bidders are players, with
strategy profiles and payoffs for each strategy profile (Milgrom, 1989; Baye, 2003).
Depending on the roles of the bidders and auctioneers, the strategies of the players
could vary. When the auctioneer is a seller, his goal will be to sell at highest
possible price. If he is a buyer, he must aim at buying at the lowest possible price
from a set of potential suppliers. Conversely, when bidders are buyers, they want
to buy at the lowest possible price. When they sell, it is rational for them to sell at
a lower profitable price than rival suppliers.
Auctions are classified according to the timing of bidder decisions (sequential or
simultaneous bids), and the amount the winner is required to pay. Using these
definitions, Milgrom (1989), Baye (2003), and Klemperer (2003) identify four basic
auction types:
• English auctions
• First-price, sealed-bid auction
• Second-price, sealed-bid auction, and
• Dutch auction
The English auction is probably the most familiar. Baye (2003) described it as ‘an
ascending, sequential-bid auction in which bidders observe the bids of others, and
decide whether or not to increase the bid’. This auction ends when a single bidder
remains; this bidder obtains the item and pays the auctioneer the amount of his
bid. There are a number of variants of the English auction

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• The open outcry auction, where bidders call out prices
• The silent auction where the auctioneer calls out prices
• The Japanese auction where bidders hold down buttons
The first-price, sealed-bid auction is a simultaneous-move auction in which bidders
simultaneously submit bids on pieces of paper. The auctioneer awards the item to
the highest bidder, who pays the amount of bid. A second-price, sealed-bid auction
is a simultaneous-move auction in which bidders simultaneously submit bids; the
auctioneer awards the item to the highest bidder, who pays the amount bid by the
second highest bidder. A Dutch Auction is a descending, sequential-bid auction in
which the auctioneer begins with a high asking price and gradually reduces the
asking price until one bidder announces a willingness to pay that price for the item.
It is important to emphasize that apart from English auctions, players bidding
without knowing what the other players have bid characterize all the other
auctions.
2. Auction theory
2.1 Optimal bidding behavior
An important issue explored by theorists was how rational bidders would behave
under various auction setups. Milgrom (1989) identifies Vickrey (1961) as being the
first to systematically investigate this issue. According to Milgrom, the bidder in a
2nd
price, sealed bid auction faces a problem identical to the bidder in an English
auction. For both bidders, the only problem each has to solve is the highest price
at which they will be willing to claim the good being sold by auction. The optimal
behaviour of each bidder leads to each offering to buy at a price equal to their
bids.
Milgrom (ibid) also demonstrates the equivalence of Dutch and 1st
price auctions by
showing that when Dutch and 1st
price, sealed bid auctions are modelled as
strategic form games, the games are identical, i.e., they have the same reduced
normal form. The sets of strategies are identical and the outcome rules that
change strategies into allocations are identical (the solution concepts are
identical). The identity of the winner and the price the winner pays will be the
same for the two auctions.
In an English auction where the value of the object is private information to
respective bidders1
, optimal bidding requires each bidder to bid until the bid
exceeds his/her private valuation. At equilibrium, the item goes to the bidder with
1
With rival bidders’ valuations being independent

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the highest valuation for a price equal to the second highest valuation. Milgrom
notes this outcome is efficient (p.8).
Vickrey (cited in ibid) shows the equivalence of this outcome to that of a sealed-
bid, second price auction with private independent values. Milgrom notes here that
if bidders are ‘price-takers’, the price paid by the winning bidder depends on
competitors’ bids alone (p.8). He further explains that a bid is just another way of
stating which ‘price offers’ a bidder is willing to accept. This implies that bidders
should accept ‘offers’, up to their bid for the object, not more. The dominant
strategy is thus for all bidders to bid their true reservation price, which makes it
rational to accept offers below this bid and none above. The existence of a
dominant strategy means one can submit a sealed bid in total disregard for rival
bids. These characteristics make a second price auction a duplicate of the open
outcry English auction.
Apart from independent private values, optimal bidding behavior has been studied
under conditions of affiliated values. In this case, the assets being traded are of
equal value to the bidders. However, there’s common uncertainty over factors such
as, in the context of the housing market, future values, changes in neighborhood
quality etc. This leads to a positive correlation between bidders’ values. The
analysis of equilibrium when the independent private values assumption is relaxed
is built upon a stronger concept of affiliation, a concept attributed to Milgrom &
Weber (1982, cited in ibid). Affiliation implies that as a bidder’s valuation rises, he
expects others’ values to rise in the sense of becoming more likely.
2.2 Do institutional details matter?
Given the equivalence of the major auction forms, one may then want to
understand why certain forms are used under certain circumstances more
frequently than others. One way to approach the issue is to see how much revenue
results from each auction type. The revenue equivalence theorem basically
answers this question by stipulating that the English, Dutch and sealed bid auctions
yield exactly the same expected profit for every bidder valuation and the same
expected revenue for the seller – with independent private values.
The next logical question, therefore, is how affiliation affects the auctioneer’s
ability to extract incremental profits associated with larger value estimates?
Milgrom (ibid, p. 15) shows that while the total surpluses are the same for the
English and the sealed-bid auctions for affiliated values, the bidder’s expected
payoff is smaller in the English auction and the seller’s expected revenue is thus
higher.
The explanation is that if price paid by the buyer can be more effectively linked to
exogenous variables that are affiliated with bidders’ private information, the
bidders can be made worse off and the seller made better off. Thus if seller has

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information about the object that would materially increase the bidder’s valuation,
then revealing this information is beneficial to the seller – bidders will offer higher
bids, resulting in a higher selling price, allowing the seller to extract the bidder’s
surplus.
An alternative way suggested by Milgrom to compare auctions is on the basis of
robustness, efficiency, transaction costs and immunity to cheating. Efficiency
considerations apply not only to the final allocation of the good to the bidder but
also include costs of bid preparation.
Lucking-Reiley (2000) argues that optimal bidding in English auctions is simpler and
more robust because it involves dominant strategies in the sense that any bidder’s
optimal strategy is unaffected by rivals’ bids. However, Milgrom (1989) notes that
auctions are susceptible to bidder’s colluding to win the bid and re-auction the
product among themselves. The strategically equivalent second-price, sealed bid
auction suffers from a weakness: the auctioneer may cheat by inserting a false bid
if he finds the second highest bid to be too low; the auctioneer may also withdraw
the good from auction if he finds the winning bid is very high, suggesting the good
is perhaps more valuable than the auctioneer first thought. Lucking-Reiley (ibid)
cites this as the reason for the relative scarcity of this type of auction.
3. Auctions in practice
3.1 Auctions in general
As noted by Milgrom (ibid) and Lusht (1996), when the quantity to be supplied is
specified in advance, English auctions are more prevalent. In the case of
procurement contracts, sealed bid auctions are more prevalent. Some auctions
generate a lot of money for the seller, while some auctions are vulnerable to
collusion, resulting in lower revenues for the seller.
According to Klemperer (2001, 2002), whether an auction makes or loses money
depends on how successfully it is designed to attract bidders and prevent collusion
between bidders. In the case of 3G phone licenses, he was able to show that design
was the critical difference between the huge revenues realised in the UK auction
and other European auctions.
In a review of European 3G auctions, he points out that in principle, the ascending
auction is flawed from the auctioneer’s perspective because it allows rival bidders
to signal plans to collude in latter rounds as well as issue threats to those who fail
to go along with any intended collusion. He further notes that ascending auctions
can deter entry from weaker bidders who know their bids can be topped by
stronger bidders.

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He contrasts this with a sealed bid which eliminates the possibility of signalling and
punishment in furtherance of a plan to collude. In addition, the improved chance of
winning encourages entry for weaker bidders, given the anonymity of the sealed
bid process. The downside of a sealed bid auction is that sometimes bidders with
lower valuations may win, leading to an inefficient outcome.
Perhaps the most important point in Klemperer’s review is that auctions must be
tailored both to its environment and the designer’s objectives. Thus in the case of
the UK 3G auction a hybrid Anglo-Dutch auction was used. Stage one of the process
involved an ascending auction, which removes the risk of inefficient outcomes.
Once the bidding got to the stage where the number of bidders was one more than
the number of licenses, a sealed-bid was used. The twin-advantages of changing
the process were attracting entrants and raising revenue. This was in addition to
deterring collusion.
3.2 Auctions in the real estate market
A fundamental issue is how revenues from property sales by auctions compare with
sales revenues from private negotiations. Lusht (1996) points out that up until the
mid 1990s, research into this issue mainly compared sealed-bid auctions with
privately negotiated sales, in spite of the fact that English auctions dominated all
the other auction forms.
Using data from negotiated sales and auctions in the Melbourne housing market
from January 1988 to March 1989, he showed that the average price from auctions
was 8 percent higher than from private negotiations. Besides, auctions tended to
be chosen for newer houses in good condition. This viewpoint is partly confirmed
for the Swedish market, where Eklöf and Lunander (2005) show that unlike
conventional auctions, executive auctions often are used to sell less attractive
houses.
From a more general perspective, Bulow and Klemperer (1996) also show that a
simple competitive auction with one more bidder will yield a seller greater
expected revenue than an optimally structured negotiation with one less bidder.
Thus if a house seller faces a number of potential buyers and the seller knows there
could be an additional potential buyer, it is better for the seller to auction the
house than negotiate.
However, there have been differences in the extent of use of auctions in the real
estate market as an alternative to negotiated sales. While they were used largely
for disposing of real estate in bankruptcies cases, they have been used as an
alternative sales method in the US up till the 1980s even though their use slowed
after that due to the notion that they led to sales of properties at less than market
value (Mayer, 1998). In contrast, auctions are an accepted mechanism for selling

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residential real estate in Australia, Scotland, New Zealand and Sweden, alongside
private negotiations (Lusht, 1996; Mayer, 1998; Eklöf & Lunander, 2005).
Previous studies cited by Mayer show conflicting conclusions about the price effects
of real estate sales by auctions. Whereas they sold in the US at a discount (Wright
1989, Gau & Quan 1992), in Australia Lusht (1996) found they sold at above market
prices. Mayer (1998) tries to explain the discrepancy in terms of:
• Differences in market conditions - in Australia, auctions were used in rising
markets, while the opposite occurred in the US market.
• Omitted variable bias – observed high auction prices may have been due to
an omitted attractiveness variable. The regressions may have thus wrongly
attributed quality advantages to the sales technique.
Mayer noted that if auctions led to sales of assets at a premium, it could only be
because they took place in rising markets, with inexperienced buyers who overbid,
exposing themselves to the ‘winner’s curse’ in the process. The price premiums
may also have been due to the novelty of using auctions as a sales mechanism and
the resultant media attention it generates. If the observed price premium arose for
these reasons, infers Mayer, they should not be sustainable in the long run.
If the research evidence from Australia showing auctions that auctions in healthy
markets lead to higher transaction prices than private negotiations are anything to
go by, then one can argue that auctions could support the development of a vibrant
housing market. This is because they would provide the right incentives for market
players, as long as the design flaws are detected and rectified.
Lusht (1996) describes the auction process in Melbourne as follows: the listing
agreement specifies the date of the auction, an advertising schedule and costs, the
commission agreement, and a reservation price. The existence of the latter is
public knowledge even though the actual price is not. The next step is to advertise
and show the house to individuals and by open house. The auction is generally held
at the property, during which the auctioneer may consult with the seller about a
minimum acceptable price.
When a sale is concluded, a 10 percent deposit is required, while the remainder is
payable within 60 days from the sales date. Potential buyers make independent
agreements with lenders prior to the sale. In the event that the purchase price
exceeds debt or requirements, the purchaser can default on the contract. An
important feature of the Melbourne auction is the open and legal use of
seller/dummy bids in the auction process, creating a perception that it boosts
prices. Another feature of the Melbourne auction is that unsold houses are unlikely
to be auctioned a second time.

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3.3 Auctions in the real estate market in Sweden
Housing sales in the Swedish real estate market is characterized by auctions and
private negotiations. The auctions are either conventional English ascending-bid
auctions or executive auctions. The various brokerage firms organize the
conventional auctions, while the Debt Enforcement Administration
(Kronofogdemyndigheten) usually conducts executive auctions as the last step in
the judicial process of debt collection.
Since the English auction format is the standard format in the housing market, they
obviously would suffer from the collusion and entry-deterrence problem. However,
the design flaws may not provide sufficient grounds for its abolition as a market
mechanism. Once again, we argue that if auctions could lead to higher prices than
from private negotiations, then it could be useful for the development of a vibrant
housing market. In that case, the way forward would be to explore ways of refining
the design to eliminate these flaws. As shown above, the hybrid auction format
used above for the European 3G auction provides a powerful example of how the
current plain English auction can be improved.
In a study of executive auctions in Stockholm, Eklöf and Lunander (2005) state that
conventional auctions are often ascending-bid auctions, with the bidding procedure
lasting for days. They point out that this gives potential buyers time to evaluate
how their finances affect their chances of buying the object. They also state that
brokers sometimes mediate loans for the buyer and bidders can condition their bids
on successfully obtaining a loan. They rightly infer that this is financially risky than
in executive auctions where the down payment, 25 percent of the value is lost if
the winning bidder doesn’t pay the rest.
The second risk at an executive auction is what they called a real value risk: under
executive auctions, the building is sold as is, so the seller cannot pull out of the
transaction upon discovering brokers/sellers have withheld information about
hidden damages to the property. Bidders at a conventional property auction do not
have to deal with this risk. They also point out that the nature of executive
auctions imply that buyers interested in normal property in the exclusive areas of
Stockholm should not be expected to be interested in executive auctions of
property in Stockholm.
3.4 Factors affecting successful auctions in real estate
The primary issue in the use of auctions in real estate, it has been argued, has
been how sales revenues from auctions compare to revenues from privately
negotiated sales. However, as noted by Ong, Lusht, and Mak (2004), less attention
has been paid to the conditions for auction success, defined as concluding a sale.

11. 11
Using data from Singapore on auctions of residential property from 1995 to 2000,
they find that poor market conditions diminish the probability of sale; however,
the higher the potential number of bidders2
, and better the identity of the auction
house the higher the probability of sale. Distressed properties were more likely to
sell. They also find that more homogeneous properties (apartments and
condominiums) are more likely to be auctioned. More centrally located properties
were also more likely to be sold than properties in peripheral locations. It has to be
noted that the preferred auction format here is the English ascending bid auction
and that attitudes towards housing sales by auction is similar to that of the US
(Asabere and Huffman, 1992 cited in ibid). Thus the number of residential sales by
auctions was still relatively low by the late 1990s (ibid, p.5).
Mayer (1998) in his comparative study of auctions in Los Angeles in the mid 1980s
and Dallas during the late 1980s finds evidence to support an earlier theory (Mayer,
1994) that auctions sell property at a discount. Nevertheless, he also finds
evidence suggesting that auctions are a viable sales strategy for sellers when the
latter can hold large auctions and enjoy economies of scale in advertising and
commission costs.
3.5 ICT and online auctions
Online auctions are a growing phenomenon, with companies like e-Bay attracting
millions of visitors on a regular basis. Walley and Fortin (2004) formulate a model
of online auction consumer decision process. They tested the extent to which
factors such as auction reservation price, the disclosure or otherwise of the reserve
price and the amount of initial bidding history in the auction impact the final sale
price as well as overall interest in the auction.
They found that the value of the reservation price, and its disclosure, have a
significant impact on the final sale price. Their explanation was that the disclosure
of the reservation price leads to an increased interest in the auction leading to an
increased final selling price. Conversely, non-disclosure of a reservation price gives
rise to the need to create interest in the auction, which only occurs if more bidders
participate. Yet, they cite a previous study by Smith (1989), which shows that
under conditions of increased participation, risk and competition averse bidders
will withdraw at higher reserve price levels. They also found that the final price
obtained is lower, as the average experience of the bidder rises.
2
An indicator of market interest

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4 Conclusion
Auctions have grown in importance as a way of trading not only in art and antiques,
but also a wide range of goods including offshore oil and telecommunication
licenses, real estate, procurement contracts and even simple consumer goods. Four
basic types of auctions are used depending on the good and the objectives of the
auctioneer.
English auctions and second price sealed bid auctions have been shown to be
strategically equivalent, as has first price sealed bid and Dutch auctions. Under
conditions of independent private values, all the four auction types lead to
identical revenue for the auctioneer. However, when bidders’ valuations are
affiliated, the outcomes are a lot less certain.
Klemperer’s (2001) discussion indicates that the two most important issues in
auction design are encouraging new entrants (usually in order to maximize
revenue) and how to discourage collusion. Ascending bid auctions of houses are
susceptible to collusion between bidders; bidders can collude to end an auction
quickly at a low price or bid the price high enough to drive out other bidders. Thus
if there is a strong belief among potential bidders that there are strong bidders
who will eventually top their bids, they will be deterred from entering the bidding
process. Some ascending auctions may also suffer from the winner’s curse, causing
especially weak bidders to bid cautiously leading to less than optimal prices for the
seller. It may even worsen the entry deterrence problem, which then opens the
door for strong bidders to collude.
Sealed bids, notes Klemperer (ibid), are relatively immune from collusion since
bidders cannot use their bids to send signals, unless the sealed bidding process is
repeated a number of times among the same bidders. Since the outcome in this
case is relatively uncertain, it is relatively advantageous for weak bidders to enter
since they could win more easily than in an ascending auction. Klemperer (ibid)
argues that the entry-attracting feature of sealed bids makes it harder to collude,
rendering it competitive in the process.
It is easy to agree with Klemperer’s proposal for creativity in auction design. In the
context of the housing market, his suggestion of a hybrid Anglo-Dutch auction in
stages deserves consideration for the Swedish housing market since it achieves the
twin goals of attracting entry3
and discouraging collusion.
Typical design problems occur when the auction process is not transparent in the
sense of bids not being transparent, public, and with no deadline, then there is a
real risk that the auction could lead to irrational behaviour on the part of both
bidders and auctioneers. For example, when bids are not binding, people can bid
3
Of weak bidders who need housing, which also means sellers can get attractive prices.

13. 13
on several objects, and take back their bids at a later stage. When the bidding
process, especially in an English auction drags on for too long, bidders have the
time and opportunity to collude and drive out the competition. The seller can also
stop the procedure at a later stage, or award the good to a buyer without having to
explain why a particular buyer was chosen.
Auctions in real estate are not that widespread and their use varies across
countries. While the experience from Australia shows it leads to higher house
prices than the price from negotiated sales, other research has shown that their
use may lead to assets being traded at a discount or a premium depending on
market conditions. Indeed market conditions may improve or reduce the chances of
a successful auction, defined in some of the literature as the probability of sale.
Quality differences may also play a part. Research from Singapore confirms
traditional theoretical predictions that the number of bidders is critical. In
addition, the identity of the auction house increases the probability of sale. They
also find that more homogeneous properties (apartments and condominiums) are
more likely to be auctioned. More centrally located properties were also more
likely to be sold than properties in peripheral locations.
The Swedish auction system is obviously vulnerable to the twin problems of
collusion and entry deterrence. However, the solution may not be to abolish it.
Instead, an initial research priority will be to investigate how to eliminate the
design weaknesses. For example, the feasibility of the hybrid Anglo-Dutch system
can be tested and compared with the current ascending bid system. It will also
facilitate comparisons between the Swedish practice and what pertains in other
markets. The sale of a growing number of items is being done using online auctions.
Recent research has shown that the value of the reservation price, and its
disclosure, has a significant impact on the final sale price. What will be worth
exploring, is how this would affect the feasibility or otherwise of an online auction
system real estate. It will also be useful to explore and compare the alternative
sales mechanisms for real estate in mature and stable markets.

14. 14
References
Baye, Michael R. (2003) – Managerial Economics and Business Strategy.
International Edition: McGraw-Hill, New York.
Burlow J., & Klemperer P. (1996). Auctions versus Negotiations. The American
Economic Review, 86(1), March, pp. 180-194.
Eklöf M. & Lunander A. (2003). Open outcry auctions with secret reservation prices:
an empirical application to executive auctions of tenant owner’s apartments in
Sweden. Journal of Econometrics, 114. pp.243-260.
Klemperer P. (2001). How (not) to run auctions: the European 3G auctions. Draft.
Lucking-Reiley D. (2000). Vickrey auctions in practice: from nineteenth century
philately to twenty-first century e-commerce. Journal of Economic Perspectives,
14(3), summer. Pp. 183-192.
Lusht K.M. (1996). A comparison of prices brought by English auctions and private
negotiations. Real Estate Economics, 24(4): pp.517-530.
Mayer, C.J. (1998), Assessing the performance of real estate auctions, Real Estate
Economics, 26(1), pp.41-46
Milgrom, Paul. Auctions and Bidding: A Primer. Journal of Economic Perspectives,
3(3), summer, 3 – 22.
Ong S.E, Lusht, K. & Mak C.Y. (2004). Factors influencing auction outcomes: bidder
turnout, auction houses and market conditions. Unpublished manuscript.
Walley M.J.C. & Fortin D.R (2004). Behavioral outcomes from online auctions:
reserve price, reserve disclosure, and initial bidding influences in the decision
process. Journal of Business Research (article in press).