Ryan: On Realtor Compensation

(Justin started the discussion here.)

I’m struck by the following: “The house that best fits my preferences is also the one that I will pay the most to get.” Initially, I thought that this was slightly misspecified, but after thinking about it for a little bit I think it’s delightfully accurate and efficiently worded. It underscores a secondary advantage to the “percentage vs. fee” argument you bring up. Many times, when we think of the principal/agent issues created in the home buying process, we think of the deal closing finalities—everyone wants the deal done, both sides’ principals and agents, but you personally (or the home seller) bear the cost of blinking first in negotiations. But that’s placing the process beyond another problem—finding the best house amongst many that best fits your preferences, within reasonable structural constraints. It may seem a bit awkward to assume that someone would engage in a large scale financial transaction for something that would best fit your preferences, but there are a few of realities in the home buying process to realize:

1) We get good at figuring our preferences through repeat dealings. We have an ingrained sense of our preferences for food and clothes in light of their price not because we think about it any more than our preferences for a house, but because we get a large number of trial-and-error processes to fine-tune it. Houses, for most of us, don’t fit in here. And if you don’t believe that, consider your comfort level in finding an apartment that fits what you believe you want versus a house.

2) House-hunting is a time-intensive process; given this and the above point, it’s all the more important to incentivize the agent to find a house that matches well with the principal because it’s quite possible that the principal could end up purchasing a house that isn’t the best available. If it is a flat fee, like you mentioned, it doesn’t matter that the agent tries to find the best house, but one the agent will simply will engage in a transaction for, blind of the fact that a better match would yield the agent a larger sum under the percentage structure since the principal will pay more for a better match.

As an aside, time really plays a large role in buying a house—and in most of the instances, realtors can “out-wait” the principal, whether it’s moving to a new locale for employment reasons (clear time horizon) or the discovery of a better matching home in the same area (self-imposed time horizon, “we’ll-never-find-another-home-like-this”).

It’s an interesting principal/agent scenario to look at since P/A situations usually have conflicting objectives, but that’s not the case here. In the case of the shirking employee, the employee wants to less productive for the same wage. The employer wants the employee to be more productive. That’s a direct conflict. Here, it’s more a matter of degree. You want to buy a house. The realtor wants you to buy a house. You want as low a price as possible; with a flat fee, the realtor’s main goal is to close the deal. Not the same goal—that’s why we have a principal/agent problem in the first place—but not exactly conflicting, either.