In his book Freakonomics: A Rogue Economist Explores the Hidden Side of Everything, economists Steven Levitt and Stephen Dubner point out that a real estate agent has the incentive to sell a home quickly, not get the best price for the seller. Consider a home that is listed at $400,000. Assuming that a selling agent nets a 1.25% commission on the house after splitting the commission with the buyer’s agent and his agency and the home sells for the listed price, the agent will earn a commission of $5,000. The seller is left with $380,000 after paying his agent’s commission.

Now, assume that the seller holds out for a higher price of $410,000 or $389,500 net of commissions. The seller has an extra $9,500 on the sale of his home but the agent has just $125 more in commissions. Clearly, the agent’s incentive is to sell the home quickly, not hold out for a higher price. Mr. Levitt and Mr. Dubner found that sales data for homes in the Chicago area reflected the way realtor incentives are structured: when an agent sells his own house, they keep in on the market an average of 10 days longer and sell it for 3% more compared to homes sold for clients.

You might want to check this excerpt from Freakonomics on the subject of real estate agents. It includes terms you should put in a for sale ad (and terms to avoid) and this funny story related by a professor who was looking to purchase a home:

I was just about to buy a house on the Stanford campus, and the seller’s agent kept telling me what a good deal I was getting because the market was about to zoom. As soon as I signed the purchase contract, he asked me if I would need an agent to sell my previous Stanford house. I told him that I would probably try to sell without an agent, and he replied, ‘John, that might work under normal conditions, but with the market tanking now, you really need the help of a broker.’

This article has 24 comments

  1. Brilliant post. This just backs up what I posted on yesterday’s post. Glad to see that in my sleep deprived state of mind, I was able to put together something coherent. 🙂

  2. Can you not apply this same principle to any salesman that sells goods that has larger price tags? Even a car? Machinery sales? Maybe commision should be based on the % of margin in those cases?

  3. This was very clear in my mind as I recently listed (and sold) my home.

    As I result, I went with an agency that offered 1% for the listing and where the buyer’s agent would receive 2.5% (for a total 3.5%). This has a countervailing effect from the perspective of incentives. Yes the listing agent is incented on volume, but the buyer’s agent actually has more skin in the game. In multiple offer scenarios (which many urban areas are witnessing) buying agents are simply advising their clients to throw in an extra 10-20K over asking to try and close the deal – with interest rates low, borrowing costs are down, etc. Naturally they gain from this as well.

  4. The argument here is that for the selling agent the incremental return for patience and effort is low, and so incentives are insufficiently aligned.

    It’s even worse for a buyer’s agent. Their commission is a % of selling price so they get less the more they help you get a better price. When we bought our house recently, we had a great agent who was doing his best to help us (perhaps since he knew his ability to get a listing from us a few months later depended on it). But I’ve always wondered – if you’re buying with an agent, why wouldn’t you tell them “For every $1000 you help me negotiate this under the list price, I’ll give you $100”. Would align the incentives a lot better.

  5. @ Observer – interesting idea but that only works if listing price is worth a damn. In Toronto every house is listed below market value and sells for quite frankly over fair market value. My inlaws were shocked that we paid over asking, thinking that you always over 10% below asking. I tried explaining that the list price is meaningless now, but no go…

  6. I was considering something similar to Observer’s scheme, but with the selling agent when I sell my home. I was thinking of offering the agent 10-20% of the amount they could sell it above the “expected” price (I would figure out an “expected” price with the agent *before* mentioning the incentive, so that it’s as impartial as possible).

    I still might do this, but wonder if it would be breaking any real estate agents’ rules or codes of conduct, or if there were any other considerations.

    Any thoughts on this incentive scheme?

  7. On top of wanting the quick sale, it is common for Real Estate Agents to get referral fees from mortgage brokerages that get sent the business. Some Real Estate Agencies even have a mortgage brokerage in house, thus encouraging the Agents to refer in house for the profit and the referral fee. I know a few people who got a poor deal on their house, and then horrible service from the in house mortgage broker. The agents pushed them quite strongly to go to the in house broker. My advice is shop around for price and service. Make sure you get the best service, because you may have to live with it for a few years.

  8. Canadian Capitalist

    @Paul: I’m not very familiar with other fields where agents receive a percentage of the sale price as commissions but yes, the same logic would apply.

    @David S.: Good point. Even if you do FSBO, it makes sense to offer a buyer’s agent 2.5%. They then have the incentive to close the sale.

    @Late Student: I’ve seen this idea batted around, where you pay the agent a big chunk of the price above market value. Not sure if anyone has done this though. I’d imagine, the agent is taking the risk of doing all the work and ending up with nothing if the home sells at or below the strike price. Perhaps, a combination of the two would better align the incentives.

    @Observer, @Geoff: Good points. With an incentive system of offering a portion of the selling price above a strike price, the strike price should be set correctly. If it’s set too low, the agent could walk away with a much higher commission than the traditional model.

    @Jerry: Interesting point and I hadn’t thought of it. When we purchased the home, we hired the mortgage broker referred to by our agent. It makes total sense that the real estate agent could receive a referral fee. I did shop around and made sure that the mortgage rate and features were the best around. But there might be home buyers who aren’t quite as diligent. This sounds like a whole other can of worms.

  9. Just to be clear, in the scheme in my post above the incentive would be *in addition to* the regular commission.

    If it sells below market value, the agent gets regular commission, but they now have an incentive to try to sell as high as possible. No real downside for the agent, but if they can get a good price for me, I’m willing to share!

  10. Personally, I don’t have any problems with real estate agents. I had one sell my Toronto condo in four days and she earned a 5% commission. But she was sharp as a whip! She brought in her own interior designer to clean up and stage my condo with her own money and also fixed a few small things in order to make it show better. The results speak for themselves!

    Real estate agents live a lifestyle that I personally don’t care for… Although they may not work as hard on an hour by hour basis, they are expected to be on call nearly 24 hrs a day, 7 days a week! That’s the part of their job that I simply wouldn’t be able to deal with – when I leave work, then I don’t even think about work!

    – Phil

  11. Here is an incredible article about car salesmen. As far as how commission works, they get paid a percentage of the profit on each sale, and it escalates, so they have an incentive to gouge the customer for as much as they can. Which is what is best for their employer, so no conflict of interest there.

    Similarly, although few people do it you can hire a broker to find you a car. They get paid a flat fee, so although there’s no financial incentive for them to get you the best deal possible, they do have the incentive of referrals and repeat customers, and there is no conflicting disincentive like there is with a buyer’s real estate agent.

    • Canadian Capitalist

      @Aleks: Thanks for the link to the inside world of car salesmen. I’ll highlight it in a future post, so at least car buyers have an idea of what they are dealing with. Though at some level, I also felt sorry for the salesmen. It must be a hard life constantly hustling for a sale. And if you don’t make a sale, you go hungry. That must be very stressful to deal with.

  12. Yeah, it’s kind of like The Wire in the sense that you can’t demonize anyone involved, it’s the system that forces people to behave less humanely. The only people I would say deserve scorn were the guys who torpedoed the deal with the Asian family by trying to change the terms. That wasn’t in anyone’s best interest.

  13. CC says:”
    Though at some level, I also felt sorry for the salesmen. It must be a hard life constantly hustling for a sale. And if you don’t make a sale, you go hungry. ”

    Agreed, hard to hate the monster, when you understand why the monster turned out that way, right?

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  17. I agree with Jerry when we purchased our house both agents were with Remax. In negosations, the selling agent did not want to give us 7 days for mortgage approval and insisted we use their inhouse broker. We used their broker ( broker A) who was with Morgage Intelligence. Before this I had spoken to another mortgage intelligence broker (broker B), when he found out that we had bought a house , he harassed us about all the work he had done even though he had not submitted an application. Five months later, I left 3 messages with broker A which he never returned about locking in our variable mortgage. When I finally reached him he snapped at me do whatever you want. Five years later broker A contacted us about helping us arrange a mortgage but I had used someone else.

  18. Like anything in a capitalist world, the buyer needs to be wear. In Canadian Capitalist’s example, a purchase price increase of $10,000 is only a $125 commission increase for the agent. What ends up in their pocket, after the broker takes their cut, is even less. So, it’s no wonder they aren’t all that concerned with the final sale price.
    That being said, a good agent will be just as concerned about your referral, as they will be about their commission. A higher referral rate = higher volume of sales = higher level of income. I recommend getting a comprehensive referral from a trusted source. This should increase your chances of ending up with a real estate agent that cares just as much about service as they do about the bottom line.

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  21. Interestingly, reducing transaction costs will likely push Canadian real estate into bubble territory.

    It is not clearly in a bubble today, however:
    http://www.planbeconomics.com/2010/02/15/canadian-housing-bubble/

  22. Carl: the kind of mortgage brokers you ran into are amateurs and they put a black mark on other hard-working brokers. They even stain the reputation of the real estate brokerage. Sometimes I question the ethics of real estate agents. There are some who are exceptionally good but trying to find those are like looking for a needle in a haystack.

  23. Thanks for the kind words. It’s taken me years to understand some of the things I wrote about in the article (and am still continuing to learn). I hope it will help in your real estate investing business