I’ve spend a lot of time ranting about the perils of paying the typical 1%-of-assets financial advisory fee. Today, I thought I might change gears here and turn my sights towards the real estate industry.
There was an interesting court decision out of Missouri recently. The dispute revolves around pricing practices for real estate brokers. I’m no expert on the real estate brokerage industry, but my understanding is that the gatekeepers to the multiple listing services (MLS) – essentially just databases containing information about homes for sale – require all firms or agents to force home sellers towards accepting a 5-6% commission structure that pays out both the seller’s agent and the buyer’s agent. This means that if you want to use the MLS to sell your house (and you likely do), then you cannot easily “decouple” the payment you make to your own agent from that made to the buyer’s agent.
And the costs can be substantial. If you sell a house for $1,000,000, the buyer pays $1,000,000, but the seller receives only $940,000 – $950,000. The real estate agents (and their brokerage firms) divvy up the remaining $50,000 – $60,000.
I don’t like this set up for a few reasons:
#1 – Same amount of work
As a financial advisor, it doesn’t require more effort or work to manage a portfolio of $1mm vs. $2mm. Some advisors will dispute my assertion for a variety of reasons, but I don’t ever really buy their arguments. Like most advisors, I follow a repeatable investment process for all of my clients. And the work involved has almost nothing to do with the size of a client’s portfolio.
My guess is a similar dynamic exists for real estate agents. When listing a house for sale, the agent likely follows a process that might include the following steps:
- Help the seller get the house tidied up, staged, and ready to show to buyers
- Take pictures and advertise the property to the relevant online services
- Conduct open houses and negotiate offers
- Help with any issues prior to closing
And this process is likely to be highly repeatable regardless of the value of the property. Doesn’t it then logically follow that a real estate agent puts in about the same amount of time/effort to sell a $500,000 house vs a $1,000,000 one.
And if that’s the case, then why should the owner of the $1,000,000 house pay twice as much for the same work?
#2 – Why can’t the buyer negotiate their own commission?
The whole dynamic of forcing the seller to negotiate the total commission upon signing a listing contract seems silly. Are buyers not able to handle their own negotiation? Wouldn’t it make more sense for buyers to search around for an agent and pay them directly?
#3 – The rise of online services
Before the internet came along, if you wanted to buy a house, you needed to contact a real estate agent to actually help you find a property, because they were the main repositories of information about available houses (e.g. they were the gatekeepers for the MLS). But nowadays there are quite a few websites that offer comprehensive insight into the MLS, all for free. If you want to buy a house in a specific city/neighborhood, it’s trivial to pull up all of the available properties in your target area and get detailed information on each one in a matter of minutes.
This change indicates that the value provided by a buyer’s agent has diminished. Certainly not to zero, but likely to something less than 5-6% of the transaction price.
#4 – What’s so wrong with a flat or hourly fee?
I guess the obvious answer to this one is that real estate agents and firms would make less money. But maybe not. I imagine the very best real estate professionals could still command high fees.
I imagine many seller’s agents would argue that the typical 5-6% commission incentivizes agents to seek out a good deal for their clients. If the house sells for more, then the agent makes more money, right? But shouldn’t the buyer’s agent try to bring the sale price down? Wouldn’t their efforts cancel out?
The economists behind Freakonomics looked at real estate agents a long time ago and concluded that agents don’t really help their clients get the highest or best sale price, but rather push for the fastest possible transaction. And this makes sense. If an agent is selling a $500,000 house, but decides to work extra hard an gets an offer at $525,000 (or 5% higher), then the agent stands to make an extra $750 (3% of $25k). Even less when you consider that the agent needs to share as much as half of their fee with their brokerage firm. Real estate agents want to make fast deals, not the best deal possible.
When you actually look at the services provided by real estate agents, an hourly or flat fee seems to make the most sense. Are you are a buyer and want an agent to come along to look at some houses with you? Then why not pay per showing? Look at 50 houses, you’ll pay a lot. Look at 2 houses, you’ll pay a little. Same thing with selling agents. The owner could pay a fee for staging, photography, paperwork, open houses, whatever. You need more help, you pay a higher fee. The amount of the fee scales with the work required.
#5 – Too many inexperienced real estate agents
Much like financial advisors, the barriers to entry for new real estate agents are fairly low, especially compared to other professions. In Michigan, real estate agents need just 40 hours of education while barbers need 1,000. In what world does that make sense? A bad haircut likely won’t cause financial ruin, but a bad home purchase surely could.
Combine low barriers to entry with big potential commissions and you have a strong incentive for people to enter the real estate industry. And this has resulted in a glut of real estate agents. In fact, there are more real estate agents in the US than homes for sale. I imagine this dynamic makes it nearly impossible for a new agent to gather any real transaction experience, which unfortunately means that many real estate agents are under qualified. And much like an inexperienced financial advisor, an inexperienced real estate agent has the potential to visit huge amounts of financial damage on their clients.
Some industry supporters claim that the brokerage firms provide robust training for new real estate agents so we don’t need to worry about anyone being under qualified. However, I’m skeptical.
Why would a brokerage firm invest any capital to train people who will most likely be out of the industry within a few years? I’m sure some brokers are better than others and some may even actually follow through on providing good training for new agents. But it’s unlikely that the standard of training across the industry is very good. I’ve seen this dynamic in the financial advice space as well. Large firms hire a bunch of junior advisors, give them some rudimentary training for a few months, then tell them to get out and sell. And 90% of those advisors end up out of the industry within 3 years!
I’m sure most real estate agents will disagree vehemently with my read on this situation and the development of the court cases. And I am open to hearing counter-arguments. However, my sense is that, much like the financial advice industry, there is a mountain of inertia keeping these commission arrangements in place and real estate agents are anchored to the status quo and therefore have some built-in bias. After all, people are loathe to change their minds and if the real estate industry has charged fees the same way for the past 100 years, then it’s going to be very difficult to change it now.
A better way?
If I were to design an optimal commission structure for real estate agents, I would start by decoupling the buyer and seller. Each party would need to negotiate with and pay their own agent directly. That’s an easy win. I know some loans – such as those offered by the VA – don’t allow buyers to pay a commission, but I think that could be fixed with a simple policy update or financing the buyer’s agent fees in the loan amount.
For the seller’s agent, you could either go 100% flat/hourly or split the difference… and go with something like this:
- Seller agrees to pay agent a fixed amount to compensate for the time/effort required to list the property (fixed component).
- Seller and agent agree on reasonable fair market value (FMV) for the house and if the house sells above the FMV, the agent receives an additional payment equal to some percentage of the extra value (variable component).
As an example, let’s assume a FMV of $1,000,000 and a fixed fee is $3,000 (which would cover 30 hours of work at a rate of $100/hour). If the house sells for $1,000,000 or less, the agent earns only $3,000. If the house sells for more than $1,000,000, then the agent earns $3,000 + a share of the sale price that exceeds $1,000,000. I don’t know what an appropriate percentage would be for the variable component. Maybe 10%? At that rate, if the agent can eek out a sale at $1,010,000, then they would earn an extra $1,000 (or a 33% increase in commission). If the agent can spark a bidding war, and the house sells for $1,100,000, then the agent would earn an extra $10,000.
The goal would be to compensate the agent for generating value above FMV, while still compensating them fairly for the time required to prepare the listing. If the agent comes in and sells a house near FMV, I would argue they didn’t generate much value. They should still be paid for their time, but that’s it.
Obviously, there are issues with this arrangement. Agents will push hard to convince the seller to agree to a low FMV. But the solution could be as simple as getting a third-party real estate appraisal (or an average of 2-3).
There are probably other things I’m not thinking of and maybe smarter minds than me can figure all of this out. At the end of the day, I think real estate agents offer a valuable service. They provide expertise with large financial transactions that most people rarely deal with. However, I think there’s plenty of room for improvement on the current way of doing things.
