Wednesday, February 04, 2009

Incentives for Realtors

When you are looking for a house, one of the first questions the real estate agent is likely to ask is how much you can afford to spend. The prudent customer will think twice before giving an honest answer. Realtors, after all, are paid a commission based on the price of the house. If you tell her you can afford a four hundred thousand dollar house she may, if she is competent, find you the best four hundred thousand dollar house in the city. But she has little reason to look for a three hundred thousand dollar house that is almost as good.

I have a solution to this problem, although an imperfect one. What you want is not the best house you can afford but the house that gives you the maximum surplus, the largest possible difference between what it is worth and what it costs. If that is the house you want, perhaps you ought to reward the realtor on the basis of how good a job she does of finding it.

Under my system, each time the customer looks at a house he tells the realtor what is the highest price he would pay for the house. In order to keep the benchmark from changing during the process, that price should be defined on the assumption that the alternative is renting, since otherwise it will in part depend on the other houses he has so far seen. When the customer finally buys, the realtor's commission is a percentage of the difference between the highest price the customer said he would pay and the actual price paid.

This system has two advantages. First, it gives the realtor acting for the buyer a direct financial incentive to do as good a job as possible of helping the buyer bargain the seller down. Second, it gives the realtor an incentive to find the right house, the house that maximizes the net benefit from buying it.

It is an imperfect solution for at least two reasons—putting aside the difficulty of getting the profession to adopt it. The first is that the customer has some incentive to lie, to understate the value of each house to himself in order to reduce the commission he will have to pay if he buys that house. The second is that it ignores the cost of search to the realtor. As long as a dollar's worth of extra search produces more than a dollar's increase in net benefit, it is in the joint interest of realtor and customer to continue searching. But the realtor gets only a fraction of the net benefit as commission, so it is in her interest to stop searching well before that point.

One possible explanation for the present system is that people regard a house as a good investment—the interest is tax deductible, and everyone knows, or used to, that house prices always go up. If it is a good investment, it makes some sense to buy the most expensive house you can finance, even if the actual benefits of living in the house don't justify doing so.

That argument looks less convincing now than it did a year or two back.


Jock Coats said...

I've heard of this before - I think in the UK when a buyer hires an agent this has been one of the ways of paying them available for a while. Of course not many buyers hire an agent here - we go to the vendors' agent who only has one client and one instruction - to maximize what they can get for the property!

Anonymous said...

I'm not sure I see any problem here (this may be down to a difference between UK and US practices).

As I understand it (and as it works in the UK), the seller places his property on the market through the estate agent (realtor) who acts to maximise the selling price for his client. Since he receives a direct commission on the selling price, the estate agent has the correct incentives.

Buyers then go to many competing estate agents and ask for details of all suitable properties within their price range. It is accepted that sometimes buyers will go above their nominal range for particularly good properties, so estate agents usually include some higher-priced properties in the mix. Buyers get to see what's available - and the more they look around (the more estate agents they visit and the more newspapers they read) the more options they find. They can bargain with the sellers, through the estate agents, by offering less than the asking price. So they have the right incentives too.

dWj said...

I'd like to note that the second "problem" is much less severe for your proposal than it is for the current set-up.

Seth said...

Even a seller's agent doesn't have the correct incentives: suppose he can get a price $2,000 higher by spending an additional 4 hours of work. That's $500/hour, quite nice pay, so he should do it, right? But he only keeps $15 of it, so he doesn't.

Buyers and sellers have the right incentives, by definition: it's their money. Agents can't have the right incentives, the trick is to get their incentives as closely aligned with the right ones as practicable (while keeping costs reasonable; giving the selling agent 100% provides the right incentives, but isn't reasonable).

Anonymous said...

The agent's incentives are close enough to correct, and as good as employees' and managers' incentives usually are in business. It would not be economically efficient for them to spend more than a few percent of the increase in selling price, because that's a costly activity - an economic loss - whereas changes in the price are mostly transfers. The "profit" from moving house is usually only a small fraction of the house price. This is part of what sets the market rate of commission.

VangelV said...

I am sorry to divert from the topic David but I was wondering if you had any comment on the commentary by Paul Kanjorski. He was talking about a collapse of the US economic and political system because the banks are insolvent and foreigners were pulling money out of the US. It seems to me that this topic deserves some attention and discussion. It may be time to discuss the Austrian interpretation on the nature of fiat money and the role of central banks.

Synova said...

Maybe offer to pay a commission on the difference between what you've been "qualified" for and the lower price you actually pay?

My gut feeling has always been that there is something fundamentally "off" with viewing your home as an investment. At least the one you plan to live in. Everything seems designed to get people to remain in as much debt as possible... starter houses and then moving up and always having 30 years left on your mortgage, when my *gut* says that paying off a smaller house as values, and prices, and income goes up means far more money to use or invest and a place that is paid for to retire.

Moving as much as I've done the closest I've gotten is buying a 70K fixer with cash after moving out of California just before the bottom dropped out of housing there. We had to move again for work, though, so that didn't last.

Still, I tell my kids to rent below their means, when the time comes, if they possibly can. And to buy smaller than they can afford, when they get to that point. It's human nature to over-extend and it's *miserable*.

Anonymous said...

David, are you aware of the following ad?

Any chance this might wake a few people up who argue from consensus?

WY said...

I share your view that if a buyer hires an agent, incentive to the agent does not align with the buyer's interest.

Seller, seller's agent, buyer's agent all aim for higher price.
Buyer is the most disadvantaged in terms of info asymmetry.

Seller has info of house. Agents have info on housing market (supply and demand).

WY said...

Wonder whether a system as below will work:

Buyer agent's commission, paid by buyer; is divided into 2 parts;
1)% of final price
To compensate for searching cost
2) % of difference between seller quote price & final price
The % should be higher to give incentive.
This is to compensate for negotiation skills/efforts to push down seller price.

Likewise for seller agent;
"% of difference between buyer quote price & final price" used to compensate for negotiation skillls/efforts to push up buyer price.

If buyer understates buyer quote price, it gives incentive to seller agent to negotiate up price. It increases seller's cost, reduces ability of seller's ability to sell at lower price & risk failing the profitable transactions, which is disadvantaged to buyer.
Same arguments go for seller who overstates seller quote price.

Anonymous said...
This comment has been removed by a blog administrator.
Anonymous said...

that argument wasn't really convincing a few years ago either to anyone who put the least bit of thought into it.

There are two components to a real estate investment that make it potentially a good investment.

One is appreciation. Long term this averages out to roughly equal inflation. Good bets may sightly exceed inflation, while bad ones will not quite equal it.

The second part of the investment is cash flow. Your home building is usable, and people will pay you money to let them use it. This money, minus what you spend to keep the property maintained is generally positive, amounting to a regular payoff for your investment.

In practice, most people, rather than collecting a payoff, use this cash flow to pay a mortgage on the property.

A large class of property owners, do not collect this cash flow directly, but instead live in the property themselves. They can be said to collect it indirectly because they are not paying rent to live somewhere else, which they would have to do if they did not own the property. They are consuming it, but it is replacing something they would otherwise have to consume anyway.

But now we see why the "buy the biggest house you can afford because it's an investment" meme was always a canard.

A house whose mortgage plus upkeep is roughly equivalent to what you would choose to pay to rent an alternative property (and which you plan to keep for at least 4-5 years) is now, and in all but the top of crazy boom times has always been, an excellent investment.

But the extra, the portion you pay above and beyond what would be equivalent value to what you'd otherwise pay for in a rental, *that* is not a particularly good investment. It is speculative with a relatively low expected return.

Or alternatively, it's a good investment, but bundled with a significant piece of consumption ("renting" a more expensive house).

Only in massive boom times does appreciation alone look like even a reasonable investment, and only by ignoring the real long term expectations and assuming that booms are the only thing that ever happens.

Art Vandelay said...

WY writes: "Seller, seller's agent, buyer's agent all aim for higher price."


Sellers aim for higher price. Buyers aim for lower price. Sellers and buyers' agents aim for a sale. The price is secondary.

Let's say 5% commission. My buyer is adamant he won't go past $500K. Your seller is digging in at $510K.

I stand to make roughly $12,500 (half the $25,000 commission), as do you. Our respective portion of the commission on that $10K difference is $250.

Our incentive is to bag the sale, and not risk losing the sale over a tiny increment in the commission.

I will talk my client into paying a tiny increment more (amortized over 25 years at 6% that extra $10K is $60 a month - the cost of cable) and you will talk your clients into accepting less.

You also imply that there's an informational differential. Maybe in the U.S., I don't know. In Canada, agents have the most information, yes. But the same market information is available to sellers through their agents, and to buyers through their own agents. The only reason not to come armed with information is to willfully not seek it out.

WY said...

Thanks Art Vandelay for your view.

The small difference of commission in your example is due to small difference in seller price -buyer price.
Furthermore, even if the difference of commission is small, if it can be achieved with slight efforts, agents will still work towards higher selling price.

Information asymmetry exists between buyer and buyer’s agent. When this information asymmetry occurs and buyer’s agent stands to earn more from this information asymmetry, buyer’s agent may not tell the whole truth to the buyer.
For example, buyer’s agent can tell the buyer:
1. Your price is too low in current market, the seller most likely won’t sell to you, but I can try to negotiate (who knows)
2. I have another client who like to buy this house (who knows), he is willing to pay at higher price. Pending decision now. Whoever confirm and pay the deposit first get the house ...(turn it into a bidding war among his own sets of clients)

And to lie on these are effortless and nothing to lose for the buyer’s agent.

Principal – agent problem exists.