Real Real Estate Agents

A real-estate agent keeps her own home on the market an average of ten days longer [than she would for a client] and sells it for an extra 3-plus percent, or $10,000 on a $300,000 house. When she sells her own house, an agent holds out for the best offer; when she sells yours, she encourages you to take the first decent offer that comes along. (more)

Lecturing on incentives on Wednesday, I used the classic example of the bad incentives of real estate agents. They usually get a fixed percentage (3%) of the sale price, which mostly makes them want to close a deal as fast as possible, regardless of the sale price. This is bad for seller’s agents and positively perverse for buyer agents – they worse the deal they get for you, the more they get paid. And the scope for individual agent reputations is pretty limited, because most people only ever buy or sell a few houses in their lifetime, usually in geographically separated places.

Alex just posted on the continuing puzzle of why this fixed percentage doesn’t seem to respond to changing market conditions, arguing that neither monopoly nor signaling explains it, and suggests:

Part of the problem in the realtor market is that other realtors can easily discriminate against discount brokers by pushing their clients one way or the other. (more)

That may be why we won’t see something better soon, but my lecture prompted me to think about the still interesting question: what exactly would be a better contract between you and your real estate agent, one that would better align their interests with yours?

Searching I found this paper from 2000, which proposes that selling homeowners sell their home to the selling agent, but also give that agent an option to sell the home back at the same price, to give that homeowner an incentive to help sell. They make no suggestion about how to contract with a buyers agent.

Here is what I came up with after my lecture. On the sell side, have the homeowner sell a 20% stake in their house to the selling agent, for an agreed-on cash price. The homeowner might hold an auction to find the local agent willing to pay the highest price to take on this role. The agent turns that back into cash when the house actually sells, or if it doesn’t sell the agent can sell their 20% stake back for the same price they paid if they want to give up on the process for now. If the homeowner wants to give up on the process, a similar reverse sale would happen, but perhaps the homeowner should suffer a penalty, such as 10% of that price paid for the 20% stake.

On the buy side, I’d have the buyer agent agree to pay (20-X)% of the house purchase price to gain a 20% stake in the house at the time of the home purchase. The X% number would be the agent’s fee, which might be chosen by an auction among the local agents. Unless they could find someone else who agreed to buy this stake after the purchase, they’d have to hold on to it until the house is next sold. Perhaps for many years. Because the buyer would get to live in the house or rent it, while the agent would not, the homeowner would owe the agent 20% of some assigned rental price each month until the house was again sold. This rental price could come from a simple regression of rental prices on local home features. People would know this price wasn’t exactly right, but they could take deviations into account in setting the price X.

The 20% number in the above is obviously arbitrary. It is probably a better place to start than the 100% number in the other proposal I mentioned, being a less radical change from the status quo. But my proposal is really to have some percentage number like that, not the exact 20% number.

This proposal clearly requires the agents to take on more financial risk than they do today, and so would encourage them to organize into agent firms that jointly take on the risk together. But that seems pretty reasonable.

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  • IMASBA

    “Alex just posted on the continuing puzzle of why this fixed percentage doesn’t seem to respond to changing market conditions, arguing that neither monopoly nor signaling explains it”

    The explanation is very simple, if you are willing to see it: some stuff is too complicated and too risky (huge potential rewards and catastrophic punishment for failure) for consumers to effectively go their own way on, so they rely on “experts”, when these experts operate commercially and control many aspect of their market you get a perfect triangle of conflicts of interests. You can see this in real estate, medicine and big business in general (why aren’t shareholders cracking down on bad executives? because these groups overlap a lot). This is the edge where the difference between econometric idealizations and reality become visible, where consumers not being perfectly rational, perfectly educated actors with perfect knowledge and people who have a lot of wealth also having a lot of power to rival that of the law of the land, constrains capitalism.

    • Stephen Diamond

      some stuff is too complicated and too risky (huge potential rewards and catastrophic punishment for failure) for consumers to effectively go their own way

      Ideally, the explanation would encompass the diverse fields subject to this effect: real estate, law, and waiting; but, unless I’m missing something, your explanation is wanting for waiting.

  • Jess Riedel

    Personally, I would be very hesitant to any system that resulted in me as a homeowner being entangled with a lien for possibly decades.

    Is this over-simplistic? The agent gets 1% of the sale price, plus Y% of the sale price in excess of some benchmark price previously agreed to by the owner and agent. The benchmark would be roughly the house’s expected sales prices (or a bit lower), just based on state of the market in the region. Y would be influenced by whatever the normal variability in housing prices is, but it would be an industry standard and might be as high as 50%. If the sale is for less than the benchmark, the agent can lose some or all of his 1% base.

    This increases the marginal return for the agent on small increases in sales price. It pushes Y% of the risk from homeowner to agent. Homeowners primarily negotiates with the small number of local agents over the benchmark price. In the limit as Y->100%, the agents become pure re-sellers.

    • http://overcomingbias.com RobinHanson

      As a new homeowner, you could buy the home buyer agent’s stake away from him the day after you bought the house, if the two of you could agree on a price.

    • VV

      This would create an incentive for the agents to focus on clients whose houses they expect to sell at higher than the benchmark price and avoid those they expect to sell at lower than the benchmark price.

  • Ben

    Ask the agent what the expect to sell the house for. Offer them 50% of what they get above that.

    and in equilibrium… ask all the agents what the expect to be able to sell for, and give the contract to the one with the highest bid

    • VV

      Or, even better, ask all the buyers and sell the house yourself to the one with the highest bid.

      Seriously, it seems that you and Hanson are missing the point of what agents are for.

      • Daniel Carrier

        You only need two realters to get a good auction. They’d all consider the house to be worth the same. Namely, what they can sell it for. This doesn’t work with buyers. Each one will value the house differently. You need to ask all of them.

  • JJW14

    Why not just use a sliding scale with the real estate agent? So for example,on a $200,000 home, the agent gets 2% on the first $150,000, 6% on the next $50,000, and 15% on anything over $200,000. (Obviously the exact numbers are subject to revision.)

  • http://www.facebook.com/gavinomics Gavin Jensen

    Just for fun, I emailed this article to my real estate agent and he shot back the following response:

    “I see a couple of things. First, listing commissions are always negotiable. As a group, Realtors cannot decide on a fixed listing commission. This is monoplistic and illegal. Secondly, net listings, where an agent could get X amount or X percent of the proceeds of a sale over and above a predetermined price, are illegal in Utah as well. If they were legal, in my career, I would have had an opportunity to make a lot of money that way. Third, having a Realtor buy a share into the property assumes the the owner has any equity in the property. As an agent in that situation, I would have to have a lien on the property. This has all kinds of implications that could be negative for both the owner and the agent. Fourth, this article assumes sellers are stupid. They are not. In general, people are well-informed and are capable of making good decisions regarding the sell of their home outside of any pressure an agent may put on them. I agree, there are agents out there who are very self-interested and may put this type of stress on their clients. As in any industry, you have those who “practice” and you have those who are “professionals.” The market has a way of eliminating those who are just in it for the money. Fifth, I am a fee market guy. Home prices are a function of supply and demand. There are things an agent and a seller can do to get top dollar for the home. The agent should have an aggressive marketing strategy and the seller needs to make sure the “product” looks good to buyers. Often, both the agent and the seller fail to do their part and homes sit on the market for a long time and sell at a below-market price.
    Just a few thoughts.”

    • http://www.facebook.com/yudkowsky Eliezer Yudkowsky

      That’s amusing. My first reaction is “your real estate agent thinks you’re stupid”, but really it’s just classic thinking from non-econblog-readers.

      • http://twitter.com/speedprior Steve Bachelor

        I was giving the agent the benefit of the doubt right up until “the market has a way of eliminating those who are just in it for the money.”

  • arch1

    1) I think I see professional hypocrisy (selling agents aren’t as a group following their own professional standards), and the incentives do seem truly perverse wrt buyers’ agents. But given that agents only do 3% better selling for themselves than for clients, and given that sellers (and buyers) do have the option of holding out for better prices, is there really a big problem here?

    2) Re: “They usually get a fixed percentage (3%) of the sale price, which mostly makes them want to close a deal as fast as possible, regardless of the sale price” –

    I think this could have been clearer. The effect doesn’t occur specifically because selling agent’s percentage is *fixed* (homeowner’s percentage is fixed too, after all). It’s because selling agent’s expected $/hr to increase selling price beyond owner’s basement price is LESS than the expected $/hr of declaring victory and moving ahead on other prospective (basement-price) sales .

    • Stephen Diamond

      is there really a big problem here?

      No, I don’t think this problem has been adequately established. The realtors selling their own homes might, as an alternative explanation, be inured to the anxiety of waiting for a purchaser. Do realtors do a worse job selling customers’ homes than their own? I have no information about realtors, but attorneys do a worse job on their own civil cases than they do for clients. I expect the same psychology applies.

      But there clearly is a problem of market failure when you consider that realtors earn so much more per sale in California than Idaho, causing their gross maldistribution.

      • arch1

        Thanks for sharing this alternative possible explanation. I don’t know whether it’s correct, or even whether the original investigators considered this. But I now realize that I did not think carefully enough about possible alternative explanations such as this.

  • Blake

    Linear contracts (% of final sale price) maximize the worst-case revenue if the seller isn’t sure what actions the agent could take, according to a recent paper by Gabriel Carroll.

    If you can get agents to compete to represent you, Demarzo et al “Bidding with securities” suggests that having agent’s bid on their percentage cut will tend to yield more than having agents buy the house directly from you in an auction or bid for a threshold above which they get everything (bidding by threshold above which the seller gets everything maximizes revenue when selling a regular asset, but that has obvious moral hazard issues here).

    • Daniel Carrier

      > (bidding by threshold above which the seller gets everything maximizes revenue when selling a regular asset, but that has obvious moral hazard issues here).

      I don’t see the problem. In particular, I don’t see how it differs from anything else. They will try and get that threshold as low as they can, but they’ll try to make as much as they can however you do it. Just have an auction and let the highest bidder sell it.

      Also, this is equivalent to just selling the house directly to the realters.

      • Blake

        In the contracts I was parenthetically describing, the agent would get up to the first, say, $10,000 of the house’s final sales price and the homeowner gets anything above that. These contracts work well for assets with a currently unknown value that will be eventually realized. Here however, it makes no difference to the agent whether the house sells at $50,000 or $300,000 since he gets only $10,000, so he doesn’t want to put in any effort beyond covering his cut. At the extreme, the homeowner never gets any revenue since the house sells exactly for the agent’s cut.

        In a cash auction, the homeowner is guaranteed the agent’s bid. Since every marginal dollar of the home’s final sale price goes to the agent, there are no incentive issues, but the homeworker captures none of those gains.

        In an auction with limited liability, where the homeowner gets up to the bid of the agent and the agent gets everything above that, agents will bid more than in the cash auction since they never have to pay out of pocket. However, there might be some moral hazard problems when the agent knows the house won’t sell for much and any effort he puts in will just goes to the owner. Switching from a cash to limited liability contract generates more revenue through the auction, but less due to moral hazard. The two formats aren’t going to be equivalent unless the effects cancel out exactly.

      • Daniel Carrier

        “In the contracts I was parenthetically describing, the agent would get up to the first, say, $10,000 of the house’s final sales price and the homeowner gets anything above that.”

        I thought you meant the opposite. That the homeowner would get up to the first, say, $100,000 of the house’s final sales price and the agent gets anything above that.

        Why would the contract you give every be good?

        “Since every marginal dollar of the home’s final sale price goes to the agent, there are no incentive issues, but the homeworker captures none of those gains.”

        He captures them when hiring the agent. He just captures none of the uncertainty.

        “However, there might be some moral hazard problems when the agent knows the house won’t sell for much and any effort he puts in will just goes to the owner.”

        Really what should be happening is that the agent will have to pay if it goes less than that. Otherwise there’s no incentive for an agent not to bid high on the off chance that they can sell it for more than that. The only cost to them is interest.

  • Stephen Diamond

    Waiting, because uncomplicated by problems of possible monopoly or asymmetrical information, provides the key. We feel it is fair that a waiter receive a tip of at least 15% of the meal’s value. (But the precise figure isn’t inevitable: in Canada it’s 10%.)

    Culture’s establishment of a fixed rate based on value transacted is an adaptation based on the “unnaturalness” of commissions paid by the direct customer as a means of reimbursement. Humans have a limited number of models for “moral” relationships. Market transactions foster a model based on ratios, and the only salient ratio is one based on the value of the transaction itself. (For the “relationship regulation” model of “morality,” see Fiske’s work, described and cited in my The habit theory of morality, moral influence, and moral evolutionhttp://tinyurl.com/alsd4l6 .

  • Robert Koslover

    I’m not sure that these speculations have much value in the absence of considerations of: (1) law, and (2) taxes. After all, for most other purchases, people don’t need “agents” at all (not to mention title companies, mortgage companies, surveyors, assessors, insurance policies, termite inspections, radon gas testing, etc.!) If you want to change the present real estate selling/buying system, then you may need to simplify the laws and the tax rules first. Otherwise, almost anything you are likely to come up with will either be totally illegal or cost the parties involved plenty of additional money due to the many kinds of additional transaction taxes & fees that would likely apply.

  • light reading guide

    If one were to do a cross cultural comparison on this, a possible result explaining higher commissions for real estate agents in countries like the USA might be based on an unspoken societal multi-individual non-coordinated preference to allow some fields of endeavor to be welcoming to attractive young and middle-aged women while to a certain degree excluding in those same fields of endeavor, on a random but consistent basis, profit-trimming entrepreneurs from the universe of individual businesspeople who are not attractive young and middle aged women.

  • Ari Timonen

    So you are moving to a new home? ;)

  • IMASBA

    I wonder if the point really is for all of us trying to come up with ways to fix the problem described by Robin. The way I see it there’s something bigger going on here. There is the possibility that people on this blog will find a solution, there’s a possibility that they will not. In both cases It should have us thinking: if there is a solution we here on the blog can think of, then why hasn’t the “invisible hand” of the free market implemented it decades ago, if there is no solution (or an excruciatingly difficult one that no one here can think of in a timely manner), then why is the free market still running with this rotten way of selling homes (surely no government authority forces this method on anyone)? In either case we could conclude that bad practices that screw over many people, even intelligent ones, can continue for decades, at the very least, in a free market. In the end isn’t the point that we can think of fancy solutions all we want but that it won’t matter in the real world because getting screwed in a free market for an opaque product is inevitable, part of the game?

    • Stephen Diamond

      The way I see it there’s something bigger going on here.

      But, we’ve got some “rationalists” here: and what is a libertarian but an extreme economic rationalist? The rationalists will figure out the “optimal” remuneration scheme and compel their (successive) real-estate agents to accept it, alienating each so the house is never sold. Then they dissect the experience on Less Wrong.

  • zz

    Check the literature on “Linear Contract Performance”. There is some interesting work on this application to real estate from David Sappington and Debashis Pal:

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1782523

  • Lord

    In general, the value of a property can’t really be determined to within more than 5%. I wonder what variance came with that 3% gain. Even 10 days would cost $1000 to carry two properties.

  • mendel

    arch1 put it down to simple maths: “It’s because selling agent’s expected $/hr to increase selling price beyond owner’s basement price is LESS than the expected $/hr of declaring victory and moving ahead on other prospective (basement-price) sales .”

    In numbers: if I have to do extra work to squeeze a final $10,000 out of a $300,000 sale, I have made $10,000 if it’s my own house and $300 if it’s a client’s house (assuming a 3% commission). The incentive of working for yourself is _always_ higher than that of working for someone else, no matter how you change the system.

  • emaij

    In 2008 an agent was trying to get me to sign with him to rep me as a buyer. He wanted me to make him my exclusive buyer’s rep. He sent me his contract, which was rife with conflicts. So I edited it and sent it back to him. He decided not sign the one I provided. For your consideration: https://docs.google.com/document/d/1OESy1d1pLPc96SIUFTvoM505-DfhAq1b4ZtB-WkhLzo/edit?usp=sharing

  • carefreeestates

    I found this informative and interesting blog, so I think so it’s very useful and knowledgeable. I would like to thank you for the efforts you have made in writing this article. I am hoping the same best work from you in the future as well. In fact your creative writing abilities has inspired me. I really thought that blog is spreading its wings rapidly…

  • Edilberto Durano

    A real real estate agent is what realty businessman needs right now.
    Ed of a href=”http://www.petergreiner.com/”>PeterGreiner.com

  • Ray Schmitz

    From the practitioner’s perspective, this is entirely unworkable. Even if it could be implemented cost-effectively, the solution is much too complicated to explain to most homeowners. A slightly better solution might be to pay on a sliding scale relative to the over/under against some consensus (crowd-determined?) expected sale price. An even more interesting solution is to eliminate the commission entirely, and simply pay for the professional services rendered according to some other agreed upon pricing.

  • Edilberto Durano

    Yep. A REAL real estate agent should be reliable and efficient.
    Ed of PeterGreiner.com

  • http://www.facebook.com/goetzphil Phil Goetz

    That’s far more complex a plan than is needed. I told my buyer’s agent that instead of his commission of 3%, I’d pay him selling price * .03 * (2 – selling price/asking price) . This was when selling price was always lower than asking price.

    He said it was too hard and probably illegal for him to structure a deal that way.

  • http://twitter.com/ListedPro ListedPro Designs

    More and more people are going the FSBO route, it’s crazy.

  • http://www.firsttimebuyerni.com/ Nick

    This is an interesting proposed solution to a worrying problem. Most of us sell few houses in our lifetime and have to put our trust in the estate agents. Fortunately, the process is different in the UK – and we don’t often use buying agents – but it illustrates that we need to choose agents carefully. Talk to your agent, ask their opinion and why they take a certain approach and, if they don’t explain themselves to your satisfaction, challenge them.

  • Chris Daniels

    I think real estate agents play a very important role in real estate industry. Thanks for telling us more about the real estate agent.

    Regards
    Chris Daniel
    Homes for Cash Fast