Tuesday, March 17, 2009

Ross: On Realtor Compensation

This is the first entry in the "TPS Discussion" series.

If you are in the market for buying a house with the help of a realtor, one of the more peculiar aspects of this prospect is how the realtor representing the buyer is compensated. The buyer’s realtor, like the seller’s, is compensated by receiving a commission that is a percentage of the final sale price. This is peculiar because it would seem, at least at first blush, that the incentives of the agent are better-aligned with the opposing party during negotiations. What incentive does the realtor have to help the buyer negotiate a lower price? Why is this compensation scheme the dominant model of realty transactions?
Justin's Thoughts:

Let’s ask why this scheme has emerged as something demanded by the prospective buyers. Imagine we are in an environment where you have multiple real estate agents standing on the street and holding up a signs with different contract terms: some ask for a fixed fee; others ask for a % of the sale price. Why over time would the fixed fee realtors be selected against?

I think the answer is that the fixed fee approach places too much emphasis to complete a transaction, and actually would align the buyer’s agent with the seller more than the percentage price approach. To get a sale, the fixed fee realtor simply needs to find a house that provides positive amounts of consumer surplus. This also gives the realtor an incentive to represent any house as a structure that will give me positive amounts of surplus.

However, such a serious investment of money and time means that I want to get the house that best fits my preferences. The house that best fits my preferences is also the one that I will pay the most to get. By paying the realtor the percentage of sale price, I am incentivizing him to both complete a deal and find the house that I will demand the most. The final bargaining stage, which is typically over a few thousand dollars, is simply too small of a perverse incentive to outweigh the positive incentives created in the search process.

Furthermore, on the supply side, real estate agents ultimately will have more success when they let the buyer make the decision. Advising and getting it wrong, or appearing to get it wrong, will wind up with the agent receiving the buyer’s blame much more than the cases where the agent gets the advice right. There is little upside to the agent in a system when they take more responsibility in the negotiating process, and a significant potential downside. Buyers might also choose against the infringement on their sovereignty.

Matt Replies


KipEsquire said...

Having literally closed on a townhouse purchase last week, with the help of a buyer's broker, two thoughts:

1. The role of referrals cannot be overstated in this business. This is not quite the "Why should tourists tip?" paradox.

2. Simple mean-variance theory. There is nothing per se irrational about a buyer's broker foregoing potential higher return (i.e., but coupled with higher potential of zero return) in order to secure a higher probability of any return (i.e., even if lower).

Cheers. :-)

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