Rationality in an irrational market
Mike McCracken, president of Hawkwye Aircraft Acquisitions, argues that the pre-owned aircraft is ruled by human behaviour rather than pure economic theory. And that back-t0-back deals damage the market.
In the standard economic model, markets should perform rationally. The assumption is that buyers and sellers act rationally. In those cases where the market gets out of synch, the economic theory is they will quickly get back to equality.
All of us in the market know this is not the case in the aircraft market. Buyers and sellers do not act rationally. The results are a market place with fluctuations in price that are anything but rational.
The field of behavioural economics got its start in the late 1960’s and has gained ground ever since. It helps model real economic behavior versus theoretical rational economic behavior. It is so important that Dr. Richard Thaler won a Nobel prize in Economics for his work in this field.
These economists teamed with the fields of psychology to come up with new models that better explain the real workings of the market place. They could have saved a great deal of time by starting their studies in the aircraft marketplace.
The following is an example from Misbehaving by Dr. Richard Thaler that we can all relate to.
Suppose you bought a case of good Bordeaux in the futures market for $20 a bottle. The wine now sells at auction for about $75. You have decided to drink a bottle. Which of the following captures your feeling of the cost to you for drinking the bottle? Now take your devices and vote for the one that matches your thoughts.
- $0, I already paid for it
- $20, what I paid for it
- $20 plus interest
- $75 what I could get if I sold the bottle
- $55, I get to drink a bottle that is worth $75 that I only paid $20 for, so I save money by drinking the bottle.
What is the correct answer according to economic theory? According to economic theory the answer is $75 since the opportunity costs of drinking the wine is what it is selling for. A true econ/rational buyer would choose this answer and most economic theory is based on this. The above question and survey was given to over 170 professional economists. Here are the results:
- $0, I already paid for it (30%)
- $20, what I paid for it (18%)
- $20 plus interest (7%)
- $75 what I could get if I sold the bottle (20%)
- $55, I get to drink a bottle that is worth $75 that I only paid $20 for, so I save money by drinking the bottle. (25%)
Even most of the professional economists did not act according to rational economic theory! The results at Corporate Jet Investor Miami 2018 showed that business aviation professionals were better at answering this than professional economists!
- $0, I already paid for it (19%)
- $20, what I paid for it (8%)
- $20 plus interest (3%)
- $75 what I could get if I sold the bottle (65%)
- $55, I get to drink a bottle that is worth $75 that I only paid $20 for, so I save money by drinking the bottle. (5%)
How about sunk costs? How many times have we seen an emotional component to the sales price a seller is willing to take because he feels he is losing more money than he thought he would in real depreciation terms? Even though the next plane is selling at a similar discount?
In the appraisal world, by definition the market value of the real property is:
Current Market Valueis the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts. (Treasury Regulation Sec. 20.2031-1[b])
The components of this concept are:
- Price at which property would change hands
- Between a willing buyer and willing seller
- Neither party under compulsion to buy or sell
- Both parties having reasonable knowledge of all relevant facts as the valuation date.
- The sale is made to the ultimate consumer in the appropriate market level.
Market Value is similar to Current Market Value except that the provision for lack of compulsion to buy or sell is removed, and the assumption of a sale within a specified time frame is added.
The federally accepted definition of Value as stated in the Definition Section of USPAP is as follows: a type of value, stated as an opinion, that presumes the transfer of a property, as of a certain date, under specific conditions set forth in the definition of the terms identified by the appraiser as applicable in an appraisal.
- Both parties are well informed or well advised, and each acting in what he considers his own best interest
- A reasonable time is allowed for exposure in the open market
- Payment is made in terms of cash in U.S. dollars or in terms of financial arrangements comparable thereto; and
- The monetary amount represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.
The primary value assumptions are fraught with rationality issues. The reality as we all know, is most often there are not equally knowledgeable buyers and sellers. They also have hidden agendas that sometimes even the buyer’s agent or selling agent are not fully aware of during the sale.
In my opinion, what further complicates this, is determining what values really add value to each buyer and seller. An example: does GoGo Air-to-Ground Wifi add value? Well it certainly does to a US buyer. It is worth the parts only to a buyer in other region of the world. So, what is the correct appraisal valuation for an aircraft that has a piece of equipment that is not of any value to the buyer? Or what is the value expectation for the seller?
How do you account for the transaction cost? Transaction costs should not be a part of the valuation, however in the real world of the marketplace they are a very important factor. What is the cost of getting an aircraft from China or India to the US? Sales comparisons can become quite misleading without understanding some of these factors.
When you look at transactions, how do you determine whether each party is knowledgeable? Do you know that the seller has a use for the capital and needs it off their books to use the capital for something else. That might lead to a compulsion to sell. Or a buyer who has a capital approval for the calendar year that will go away or have to go through the approval process if not utilized in the year it was approved. Compulsion to buy? Taken to an extreme, two new interiors, one done in grays and blues, one in beiges and tans. On paper both are equal, however to the buyer, the emotional component of meeting the tastes of the buyer, might make one aircraft value plus or minus the price of an interior.
The results are the prices in the marketplace are not a rational representation of the market.
Property that has higher volumes and more of a commodity lessens these impacts.
Money markets are a good example. A dollar is a dollar and does not have an emotional component in the transaction. It is a commodity, it trades in large volumes. There are many items that trade in high volumes and while they might have some individual emotional component, like a house in a particular neighborhood, the volume of the transactions minimizes the effect of outliers.
The airplane market does not have many of the assumptions that traditional economic theory is based on, and the results are valuations that can be widely divergent. The volumes are very low and given that some aircraft models might have 20 or so trades per year or even less within close model year approximation, the results can become very subjective.
The back-to-back market exists in large part to middlemen taking advantage of these market inefficiencies. If the market was truly efficient as economic theory suggests, there would not be an opportunity for someone to make a market by doing a back to back.
In my opinion, this is one reason that back-to-backs hurt the market. They are adding distortions to a market that already has many distortions. A stocking inventory dealer is a different consideration. They actually buy the asset and have a financial risk associated with the purchase. They represent the wholesale value. The spread is the risk/reward for doing the transaction.
This is very different than the typically back-to-back where there is little or no risk, and the spread can be large by taking advantage of the lack of knowledge in the market. Some would argue, that the middleman is just using a form of arbitrage and should be rewarded for his knowledge in the market. The buyer and seller get a price they were both satisfied to receive. No harm no foul. If the transaction has full transparency, then both parties should not have an issue with the transaction costs.
The problem becomes when the middleman tells two stories and convinces one party that this is the maximum price in the market, and the other party that the higher price they are paying is the going price for a good deal. If that is within normal brokerage fees, both sides will more than likely, if they find out, not have much of an issue. However, when the fees for a little transaction risk far exceed the norms, then the market becomes distorted.
In the above example, what is the real market price? One aircraft results in two different fair market prices. In theory, this cannot happen. Were both parties knowledgeable?
What happens when someone without a brokerage agreement finds an aircraft and the seller advises they want X for the aircraft. He wants to make a large fee for finding this seller a buyer, and then tells the market that he has an aircraft that can be bought for Y and Y is significantly higher than X. The market now sees a high asking price on the aircraft . Is this the market or is this just a dreamer? Depending on how the middleman handles the situation by keeping a much higher price on the aircraft, than the seller is willing to take, the aircraft might languish on the market. The market looks slow, nothing is selling. No offers are forthcoming. The seller could have perhaps sold the aircraft in much less time for a good price and very near his expectation, but due to an aggressive middleman wanting to make an abnormally high fee, the aircraft sits on the market place. Is this market really slow or has transaction costs, which are not part of the valuation process by definition obscured the real market value?
This happens often and I had it happen last year on a Falcon 2000LX. The aircraft was not yet on the official market waiting on the new paint job. We decided not to advertise until we were market ready. We only responded to solicitations of people wanting to buy our aircraft that approached us directly. I was quite surprised to discover my aircraft, that we were going to ask in the high $13’s, was being bantered about in the market for the mid $14’s. It was not a mid $14’s market.
Irrationality exists in all markets. It is more predominate in ones with low volumes and lots of valuation variables. Prices are not public knowledge and the ones that do make it into the knowledge base might be widely divergent based on the unknowns in the transaction. It is important that buyers and sellers arm themselves with reputable brokers. Brokers who mislead buyers and sellers with pricing variations to accommodate a larger than normal transaction fee, do not build trust in our industry. In a small volume, small world, word gets out and it is only a manner of time before both the buyer and seller have a very good idea of the true price. However, even in this example, buyer and seller may not be able to fully understand all of the variables that resulted in the outcome.
The bottom line is that the aircraft market is a prime example of human behavior rather than pure economic theory effecting market values. Non-rational actions impact prices. Once you accept the irrational behaviors as the normal behavior, you will better understand the variances in the market. Using professionals to help weed through this irrational component can help make sense of values and place them in the proper context. The more the market place is represented by ethical and knowledgeable buyers and sellers, the more accurate the valuations will be.
Data driven valuations from reputable appraisers are a good starting place, however, it takes more than data to understand the actual valuations and that is where interpretation expertise comes into play.