Jul 112016
 

Real Estate Incentives

Financial advisors sometimes get a bad reputation for not having their client’s best interest in mind. Many continue to earn commissions even if their client’s portfolio is losing money. But what about real estate agents? Their compensation structure is also heavily based on commissions. They often earn a percentage from the final sale of a home. For a homeowner looking to sell, the ideal situation is to sell his house for the highest price possible. So at first glance it would appear that both a homeowner and a real estate agent would have the same financial incentive; to get the best possible deal for the seller. 🙂

mics-house

But further investigation reveals that maybe that’s not really true. Let’s say a homeowner sells his house for $500,000 with the help of a real estate agent on a fixed 2% commission. This means the realtor earns $10,000 and the homeowner keeps the remaining $490,000. To keep it simple we’ll ignore taxes and other costs.

But maybe with some additional advertising, negotiations, and patience, the house could actually be sold for $510,000. But this is when the incentive structures begin to diverge. As the homeowner selling the house, an extra $10,000 from the sale price means adding $9,800 more to the bank. 😀 Most sellers would like to see that money, even if it means waiting an extra couple of weeks to find the right buyer. But a realtor would only make $200 off the extra $10,000. For most real estate agents, putting in the extra time and effort (and sometimes even money for ads) isn’t worth the extra commission. So if the homeowner stands to gain $9,800 while the agent would only receive $200, then clearly their incentives do not align very well anymore.

When realtors sell homes for other people, they encourage them to take the first reasonable offer so they can move onto other listings. But when realtors they sell their own homes, they behave more like an owner (which of course they are) and hold out for the best offer. A study of this phenomenon was done on nearly 100,000 homes in Chicago, Illinois. According to the data realtors on average keep their own homes on the market for 10 days longer, and sell them for 3% higher in price than selling homes for their clients. The study controlled for variables such as location, age and quality of the house, aesthetics, primary residence vs investment property, etc.

So commission based incentives can be tricky, but interesting. Even if the broker and client’s incentives appear to be aligned, it may only be true up to a certain extent. 🙂 Similar parallels can be drawn for car dealers, stock brokers, and other types of commission based jobs. I have nothing against realtors or financial advisors. I respect them for helping even the most financially challenged people make really big life changing decisions. That’s a lot of pressure. Imagine being a realtor; you may not think a couple is financially ready to buy their first home, but as their agent, how could you turn them down? It’s human nature to pursue personal profit. So if we meet professionals that insist they somehow have our best interest in mind, it’s perfectly healthy to have a bit of scepticism.

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Random Useless Fact:

People generally want better treatment of others, but not if it directly affect themselves. The two polls below were taken in Great Britain.

16-07-eu-british-people-work

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14 Comments on "Misaligned Incentives"

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Yetisaurus
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Great post! I think skepticism is critical. I’ve had an experience with some real estate professionals recently which really highlighted that they’re in it for their own interests. These real estate brokers specialize in a particular niche of the market, and they routinely do exclusive listings to double-end the commission. I asked them why, as a seller, I could trust them to have my best interests at heart when I know they’re going to be representing the opposing party. How would I know that they are trying to get top dollar for my property? I was especially concerned about it because I’m a “little fish” in that niche, where most of their clients are repeat customers, so they would be more likely to try to make the buyer happy in order to gain the repeat business. They shocked me by answering honestly. They said their commission is based solely on the purchase price, so they have every incentive to make sure properties sell for top dollar. They said this is especially true because each sale they do sets the new high-water mark for the market, so if they don’t squeeze every dime out of this transaction, they end up shooting… Read more »
Purrfect
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Purrfect

What gets me riled is realtor talk including buy now or be priced out forever. And claims that RE will be up in price for years to come. If a financial advisor made similar claims they would be in hot water.

YWealth
Guest

You bring up an important point that many people may easily overlook the few times in their lives they have to sell a property. When it comes to mutual funds, a specific case of a potential conflict-of-interest is with trailing commissions that get paid out to whatever entity sold you the fund!

anonymousengineer555
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anonymousengineer555

Parents are RE agents. I bought the second house I saw. Sold it 5 years later to the first offer (in fairness was full list price). Even when its your own mom there is some truth to this.

Brian Lund at Measured Money
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I’ve often considered this same dilemma as we’ve been thinking about selling our house over the last year or so. It seems like my neighbors houses are sure selling fast. Why not start with a high figure, then slowly come down to find a sweet spot? Sure this approach may take more time, but if it means an extra $10,000-$15,000 for the seller, that’s quite a good use of time. Excellent and timely post, thanks. ~Brian

FerdiS
Guest

Great perspective! Personally, I prefer to have a buyer’s-only agent representing me when I buy and a seller’s-only agent representing me when I sell. I don’t like the idea of a single agent representing the best interests of both parties.

Stephen
Guest

Also a topic covered in that same chapter of freakanomics you covered last week. After I read the other post I was thinking about writing a similar post on this topic…i guess i’ll hold off for now!

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