Wednesday, June 25, 2008

Improving Incentives for Real Estate Agents

The fundamental problem with incentives for real estate agents is that the extra commission on a higher price is too small to be worth the extra effort.  Agents have little incentive to work hard to sell a house for the highest price possible.  The interests of the agent and homeowner are poorly aligned.

Let’s look at an example. Suppose that a fair price for Hanna’s house is $375,000, and that her current mortgage principal is $275,000. After she pays off her mortgage and pays the real estate fees, legal costs, and other costs, she’ll have about $75,000 left over. If the sale price is $25,000 higher or lower, it would make a big difference in how much money Hanna gets.

Let’s say that Rick, the real estate agent, gets to keep 2% of the sale price of the house for himself. Of course, the full cost to Hanna is much higher than this, but Rick only gets a fraction of what Hanna pays. This works out to $7500 for Rick. If the sale price is different by $25,000, it only makes a difference of $500 to Rick. He cares more about a fast sale than an extra $500 on a $7500 commission.

The way that real estate contracts are usually structured, Rick gets a percentage of the entire sale price, but he doesn’t really deserve anything for most of the price. After all, Hanna could just stick a sign on her lawn saying “For sale: $300,000,” and she is likely to close a deal quickly for only 80% of the fair price of her house.

Suppose that Rick were to get 10% of the portion of the sale price above $300,000 instead of 2% of the whole price. Now a $25,000 difference in the sale price makes a $2500 difference in Rick’s commission. This more closely aligns Rick’s interests with Hanna’s interests.

The big problem with this idea is that it supposes that all parties have a good idea of a fair sale price. With this type of commission structure, Rick is strongly incented to convince Hanna that her house is worth less, say $350,000, and that way the deal will give him 10% of the sale price above $280,000. If Rick then sells the house for $375,000, he gets a $9500 commission instead of $7500.

I have no good ideas of how to prevent this type of abuse. It seems that the idea of offering an “end-weighted” commission of the type I have described will only work for knowledgeable homeowners who have a good sense of the value of their homes.

14 comments:

  1. Is there a reason you couldn't set the benchmark price based on an independent appraisal?

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  2. Patrick: As long as the appraisal is truly independent, then this would be fine. But, real estate agents would have an incentive to recommend appraisers who give favourable appraisals. This doesn't necessarily mean that all real estate agents would act improperly or that all homeowners would be taken in, but the incentive is encouraging the wrong behaviour.

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  3. You could sell it yourself, if you felt so inclined as well, if you were retired and had nothing better to do with your time.

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  4. Big Cajun Man: Selling your own home is an option, but I think there is room for real estate agents in a reasonable system. Right now the amount of overhead is ridiculous. The MLS could be replaced with a simple web site requiring a very modest posting fee. After that, agents could act independently and keep all of the commission paid by the homeowner.

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  5. The issue with real estate agents is the monopoly MLS has on listings. As long as that monopoly exists, there's no incentive to make the system more efficient.

    The Justice Department in the U.S. has come to an agreement that will allow MLS postings to be hosted on other sites. We'll see how this free market approach affects the industry.

    Where's the Competition Bureau when you really need them?

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  6. Thicken My Wallet: I agree with you. Generally, I believe that the competition in free markets solves a lot of problems. But, many people confuse this with just letting businesses do whatever they want. In any industry that is monopolistic (like real estate sales) government regulation is needed to prevent abuses. It's high time that we had true competition in the real estate business.

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  7. I can't recall exactly what it said but there was a discussion on Freakonomics on this very issue. i.e. how real estate agents have an incentive to sell quickly but not get the best price for their client.

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  8. Michael:
    When selling my house, I was able to determine the actual selling prices of neighbouring houses by talking to neighbours and by inviting real estate agents to show me print-outs from the City records. Perhaps one could use these prices (on similar houses) as a benchmark on which to base a bonus scheme for an agent.

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  9. CC: It's been a while since I read Freakonomics, but I recall a discussion of real estate incentives. I don't recall any solution to the problem in this book, but I may be mistaken.

    Larry: You're absolutely right that recent sales of similar houses in the same area is a good way of deciding on the value of your home. Savvy homeowners can use this to structure an incentive system. I wonder whether there are many real estate agents willing accept an "end-loaded" incentive.

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  10. Freakonomics does not have a solution but what it states is that realtors sell their houses for more then their clients houses (considering all other things being equal). They provide a very similar example as you provided. In general, a realtor will try to convince you that most offers that you receive are the best that you will get because the market has changed since you listed. Why would a realtor take the risk of loosing $7500 for the remote possibility that they may get $7,700. It is not worth their effort to get an extra $200 even though that represents approx an extra $13,000 for you. Congrats to the person who convinces everyone that the current system is faulty and comes up with a new system (that actually works for the masses). This person will become very rich.

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  11. Millionaireby45: Real estate agents sell their own homes for more than they sell clients' homes -- nice. That alone is proof that the system is broken.

    The growth of the internet has improved efficiency and squeezed many "middle men" out of jobs. But, this hasn't affected the real estate industry much yet. Eventually, the bulk of real estate fees will go directly to the agents who do the work, and the rest of the system that currently sucks up so much of the money will just be a web site.

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  12. There are probably hundreds of websites already that try to replace MLS, but convincing the sellers is easier than convincing the agents. Without providing some advantage to them, it would be hard to change anything. Maybe less experienced agents are at a disadvantage and could be convinced more easily - after a while the ones who don't want to change will retire.

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  13. The need for a realtor to market your home is decreasing rapidly. Realtors like to position themselves as experts on the "biggest financial transaction in your life" but in reality most are merely a conduit to listing on their proprietary MLS system. They list your home on MLS, and subcontract out the rest of the real work to others- home inspection, title search, legal document prep, financing etc. The invention of MLS is ironically now their downfall, as it took all the "real" work out of marketing a home before the internet was invented. Open houses, networking, sniffing out leads, etc. It used to be hard work getting the word out.
    Now that tons of independant self-marketing sites have started to gain in popularity realtors will have a hard time convincing me to spend 6% on a web listing the next time I move. I can call the lawyer myself, thanks.

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  14. Zan: That's an interesting thought. Perhaps real estate lawyers could expand their roles slightly to shut out real estate agents entirely. A lawyer could provide some written instructions or a 10-minute session to show homeowners how to pick an asking price. The lawyer could also help with handling any complications in received offers and how to respond to them. The added legal fees would be far less than the typical real estate agent fees.

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