Larry MacDonald wrote about improving incentives for real estate agents in an article no longer available online. His idea to offer an agent an extra percentage of the sale price of a house over a certain amount is similar to some thoughts that I’ve been kicking around for a while.
The fundamental problem is that real estate agents have little incentive to work hard to sell a house for the highest price possible. The extra commission on a better price is too small to be worth the extra effort. 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.