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Real (Estate) Rent Seeking
The Justice Department may file suit against the National Association of Realtors (NAR) to prevent them from excluding discount brokers from access to the regional MLS systems. I'm hardly a fan of antitrust but the market for realtors is a racket. Six percent to sell a house? Outrageous!
Putting aside the outrage the market for realtors is terribly wasteful. Consider, house prices are much higher in California than in Idaho but commissions are stable at around six percent. Thus, even though the realtor's job, brokering a deal, is the same in California as in Idaho, a realtor in California will make much more per-house. As a result, there are far too many realtors in California and many of them will spend an entire year selling only a handful of houses. Indeed, many realtor's spend most of their time prospecting for clients rather than actually selling houses - this is a huge waste of resources.
The same relationship holds over time as over space. That is, when house prices go up we don't see a fall in commission rates. Instead, we see more entry. Since the same number of houses are being bought and sold, the extra realtors don't make the buyer or seller better off and sadly the realtors aren't better off either - instead the excess return is siphoned off in wasteful prospecting for clients.
Unfortunately, no one really understands why commissions are stable. The answer is not monopoly. It's very easy to enter the market for realtors. So why don't commissions fall? One can certainly point to some restrictive practices by the NAR but I don't think that is the whole or even the major part of the story.
A clue to the puzzle is that we also see stable commission rates in law (contingency fees) and in services (tipping). Why is the appropriate tip 15% at an expensive restaurant and at a cheap restaurant? Does the tuxedoed waiter really have a harder job than the diner waitress? Maybe (indeed, I have argued along these lines elsewhere) but the commonality across these very different markets tells me something else is going on.
Is it signaling? Would you distrust a realtor offering lower commissions? Again, maybe, but it's hard to believe that with so much money at stake there aren't enough people willing to take a risk on a discount realtor for long enough for reputations to be established. I think part of the problem in the realtor market is that other realtors can easily discriminate against discount brokers by pushing their clients one way or the other - that says the antitrust actions will probably not be very effective. But this doesn't explain stable commissions in law or waiting.
It's a puzzle and one worth solving. Comments are open.
Posted by Alex Tabarrok on May 10, 2005 at 07:11 AM in Economics | Permalink
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Comments
WRT realtors, I think you've nailed it. Waitresses? Call it rational ignorence. I don't want to think about how much to tip, I just want to do the safe thing and leave. Lawyers? That's signaling. Lawyers are competitive, and the stakes are always high. Nobody wants a discount lawyer any more than they want a discount army.
Posted by: Mike at May 10, 2005 8:20:06 AM
It's a pure social convention and one that will fall apart some day (possibly soon). Not so long ago one could have made these "signalling" arguments suggesting that you wouldn't want a discount broker.
Posted by: dsquared at May 10, 2005 8:37:34 AM
If one real estate agency lowers their commission rate, the others will have to match it, and they will all hate the first agency to cut the rates.
Somebody needs to be the hero (to the buyers of homes, not their agents) and start the process. Everyone will follow.
Posted by: Michael H. at May 10, 2005 8:52:07 AM
I forgot to mention that setting these commissions is a classic Bertrand competition. In practice, the players know there is no point in getting into a price war because all of the players will lose.
Posted by: Michael H. at May 10, 2005 8:58:40 AM
I think a lot of it is just uneducated consumers. Commissions are negotiable. However, the Realtors spend a lot of money promoting the idea that buying or selling a house is a complicated procedure that requires the assistance of a licensed agent. They have been using aggressive marketing for years to artificially inflate prices. It happens in other industries too, but the Realtors as a group have been very successful at it.
Posted by: Chris at May 10, 2005 9:07:45 AM
I think a big part of it is that the seller pays the entire 6% commission. Thus the selling agent (the buyer's agent) has no incentive to lower their commission because they are not cutting their own client's a break -> it won't attract customers nor referrels. So the buyer's themselves don't have much of an incentive to "be the hero" in this case, and nor do the selling agents.
Posted by: Amanda A. at May 10, 2005 9:15:24 AM
I think Michael H is on to something above. It's like those "we'll beat any price in town by 10%" deals that electronics stores have. Well, every store has the deal, so nobody cuts prices.
Posted by: Timothy at May 10, 2005 9:17:11 AM
Maybe the persistence of 6% has something to do with the perceptual gap between going the "for sale by owner" FSBO route and being willing to pay the full 6%. That is, you either see "all the value" of hiring a realtor and paying for it, or you see none of it, and decide to go it alone. The people who currently see only maybe the value of 3% in a realtor must have a pretty easy time making the decision to pay all or nothing.
Posted by: Matt at May 10, 2005 9:27:20 AM
Or, the people who see the value of 3% go to Foxtons, which in my neighborhood (NJ) advertises their 3% commissions extensively, and seems to have plenty of clients.
Posted by: Nicholas Weininger at May 10, 2005 9:48:21 AM
Amanda's argument is very persuasive. There ARE discount brokers out there (in the Washington area think Samson and the one who's signs have a Cardinal). However, there is a big downside to using them, namely buyers agents are much less likely to show a house where they only get a 2% Commisison. Since the prices are posted it makes enforcing the cartel highly effective. More importantly, since the buyers have no incentive to ask for a lower price from their agent you don't get the normal desire to cheat that undermines most other cartels. This gets right back to Amanda's principle agent problem.
Perhaps there is also a behavioral explanation. Specifically, in markets where prices have gone way up (and therefore Commissions have gone up) are also markets where people have a lot of equity in their house. If people do not perceive these assets as being as fully their"s as say cash in the bank they might be willing to give some of this money to a realtor rather than take the time to shop for the lowest price.
Posted by: Michael W at May 10, 2005 9:52:06 AM
Not to mention that not everyone pays 6% even for full service. I recently sold my house and paid 4.5% to an excellent full service realtor. Part of the difference may be that informally-connected clients can get better rates than those who just walk in off the street, so to speak; my realtor is a local specialist and I was referred to him by neighbors who'd been happy with him when selling their house. Part of it may also be the effect of Foxtons in the area, though.
Posted by: Nicholas Weininger at May 10, 2005 9:54:18 AM
Most Americans are too accustomed to fixed-price, non-haggling business relationships. Car buying nicely illustrates this point: it's one of the few commercial transactions in which it is generally accepted that some haggling is going to take place -- and we find this very stressful!
So when a home seller meets with a prospective seller's agent, he isn't going to say, "6% is too much. How about 4%?"
I wonder if it has something to do with an overly P.C. culture that doesn't want to insult someone by requesting that he lower the asking price for his services.
Posted by: Brian St. Pierre at May 10, 2005 10:31:40 AM
When we were haggling over a certain house, the broker offered to sacrifice part of his commission to bring the price down. Alas for him, we decided that even the reduced price wasn't worth dealing with the problems the inspector had found in the house.
It's a lot easier for a broker to make this kind of offer when he's starting from a 6% commission.
Posted by: Seth Gordon at May 10, 2005 10:42:08 AM
You say the seller pays the commission? In Australia commissions are (at least were when I lived there) just over 1%, in Germany 5.75% and the difference in that case was easy to explain. In Germany the buyer paid the commission and as he wanted a particular property and as the the agent had sole rights he had no bargaining power. In Germany cuts in the sale price are negotiated from the price the seller receives. In Australia where there are are several chains of agents with offices in every shopping center who list for the whole metropolitan area the seller can shop around for the best deal. I'm not sure of the US situation but I think it must be related to market structure. If sellers negotiate with one of several large chains before listing then I'm sure the price would come down dramatically.
Posted by: Jim Brady at May 10, 2005 10:46:43 AM
WRT tipping in restaurants: I have noticed that many waiters/waitresses working in expensive restaurants make a living out of their job, while the same is not true for those who work in many "inexpensive" restaurants (could it be a self fulfilling prophecy: On the one hand, inexpensive restaurants might not support the (tipping-) income required to support oneself; hence, waiters/waitresses working in these restaurants cant make a living out of their job. On the other hand, one could argue that the lower per customer (tipping-) income earned in inexpensive restaurants would be compensated by the increased traffic in these restaurants, thereby providing (tipping-) income similar to that of expensive restaurants on a total income basis. Yes, increased traffic equals more work!!!). Given my observation, and since the waiters/waitresses make the bulk of their wages from the tips they receive, I tend to tip more than 15% when I dine in expensive restaurants. Should I change my strategy?
Posted by: Madan at May 10, 2005 11:31:11 AM
The main points to me that hold up the high commissions are the talked about "price fixing" perpetrated in part by the powerful NAR (Michael H's point), the by buyers and sellers themselves being too inhibited to negotiate (Brian St. Pierre's point), and the unrealized gains in equity (that the seller does not actually see in the bank, as pointed out by Michael W).
Another way to look at it though, is that actually the buyer is paying the commission, out of the funds he pays for the home. So without an agent, say s/he pays $300K for a home, but with an agent s/he pays $310K for the home. That is more money s/he must finance. There is often a (or a perception of) "premium" for the agencies built into the prices (and in no way is this defending the high commission price). So in that sense, a buyer's agent could have incentive to cut her/her commission for their client to buy at a lower price, although this is rarely communicated to the buyer (for obvious reasons). The argument could go either way as to who actually "pays" the commission, and in reality it is seen more as a balance between the buyer and seller (often you see this in transactions with no agents involved, with the buyer and seller equally dividing the commission savings).
Posted by: Jako at May 10, 2005 11:36:40 AM
First: in the US generally, real-estate commissions are split between the seller's agent and the buyer's agent, and are paid by the seller out of the proceeds of the sale.
In the San Francisco Bay Area, 5% (total) and even occasional 4% commissions are becoming more common on properties over $700,000; 6% is rare on houses over $1,000,000. That's a pretty big chunk of the market in several counties here. So there's some price fall.
In the current market, the seller's agent is making an inordinate amount of money for the work they do, as all that really needs to be done is to draw up some standard forms, list the house on the MLS for less than one thinks it will go for, set out a lockbox key, hold an open house or two, and choose from multiple offers.
The buyer's agent, on the other hand, even if they don't offer chauffer services to look at houses, will still have to visit several houses to gain entry (using the lockbox left by the seller's agent), likely prepare several offers before one is accepted, and obtain entry for the buyer or buyer's inspectors during the (rather short) inspection process.
The quality of real-estate agents vary widely. In my housebuying experience, and working woth my girlfriend who's buying an investment property, I've met a number of agents, maybe one in four of whom seemed reasonably competent and informed. Quite frequently, the agent showing a house at an open house is not the listing agent, but a junior agent at the brokerage, prospecting for buyers. A good agent might actually deserve their 3%, but there are some who should pay for the privilege of representing me.
As to waiters, the fixed tip creates a career ladder: one starts working in cheap restaurants, and as one is ready to move up, one gets a job with a more expensive, and thus better-tipped, restaurant. In theory, the more expensive restaurants have more attentive and better service; in practice, they have more consistently good service, and better-looking servers.
Posted by: Anthony Argyriou at May 10, 2005 11:51:09 AM
Also - there's a huge conflict of interest for buyer's agents with the way commissions are structured. A seller's agent has incentive to maximize the price the house sells for, which is also to the seller's benefit, but a buyer's agent also has incentive to maximize the price paid. In a "hot" market, this can take the form of encouraging overbidding for properties, but even in slow markets, there's a quaint custom called "credit back at closing" when, for example, an inspection reveals a problem not obvious, and the buyer would rather receive a price adjustment than require the seller to fix the problem. Rather than lowering the sale price, there is a "credit towards closing costs" which has the effect of reducing the buyer's actual expenditure, while preserving the agents' commissions and keeping the property taxes higher. (Particularly in California, where property is only reassessed at sale or for significant construction.)
Posted by: Anthony Argyriou at May 10, 2005 12:14:39 PM
As noted above the buyer has no incentive to shop around for lower commisions, so the question is why don't sellers haggle for lower commisions. I think that the answer is since selling a house is something that a person does rarely, but involves a large amount of money, they want to feel that they are getting the best. If a good agent could get you an extra 10 grand for your house, your not going to begrudge them a couple of grand in commissions. Since it is hard to judge how good an agent is unless you sell a good amount of homes, going with the full commission agent seems like the safe bet. After all, if the discount agent is so good, why is he charging so little?
Posted by: sourcreamus at May 10, 2005 12:43:40 PM
The seller may consider it disadvantageous to bargain over the commission because other sellers are agreeing to a full 6%. Your house is only one of many the agent is trying to sell. If the agent is getting 5% (or 2 1/2%) from your deal and 6% (or 3%) from others she may not give your house the same effort she gives others. My impression is that realtors tend to concentrate on houses in certain price ranges, and if so the same factor could be at work.
Another possible explanation is that, since there are so many brokers, sellers will often choose one who is a personal acquaintance, making it awkward to try to negotiate the "standard" commission down.
If any of that's right, then discount firms could be successful, as apparently they are in some areas, because the seller does not have these concerns.
That said, it is possible sometimes to negotiate the commission. I think it is not uncommon in commercial transactions.
Posted by: Bernard Yomtov at May 10, 2005 1:01:12 PM
I usually tip >20% at cheap restaurants (eg. Thai, Chinese, Chili's) and rarely more than 16% at expensive ones, even less if I get wine. I feel especially bad for the recent immigrants that probably get to serve 3 or 4 tables an hour at these tiny places sprinkled all over L.A.
I agree that real estate agents are infuriating. Hopefully it will become more commonplace to negotiate rates - there's certainly no lack of supply!
Posted by: Paul N at May 10, 2005 1:21:57 PM
I have the very strong impression that in a hot market, like Washington DC, full-service real estate agents regularly go below the 6% even while maintaining an official policy that they will not. Since people don't buy houses very often, they may well be relatively successful in maintaining the perception that 6% is the norm.
Posted by: Erik at May 10, 2005 1:46:35 PM
The average real estate commission, nationwide, was 5.1% in 2003. It's been below 6% for more than a decade, and dropped appreciably as the housing market heated up. Furthermore, in the higher end of the market, commissions have always been lower, fee-for-service is more common, and many listings are nonexclusive, just as is the standard in the commercial market.
Posted by: R.J. Lehmann at May 10, 2005 2:24:36 PM
I took part in a small scale antitrust investigation of real estate broker's commissions as a lawyer working for the Federal Trade Commission in the mid or late 1970s. I don't think it ever produced any cases, however.
I believe that, as an adjunct to the investigation, the FTC economics division held a conference and commissioned papers on real estate brokerage from a bunch of academic economists. I think Lewis Wilde was one. I would imagine they were published as an FTC document of some kind.
On the substantive point, my sense at the time was that it was easier to maintain a realtors cartel than might appear from the relative ease of entry because such a high percentage of sales are done cooperatively and because some realtors tend to acquire locally dominant positions in particular neighborhoods. I don't know if these ideas would stand up under careful theortical analysis and empirical testing.
One other question I had at the time was whether some higher than zero commission rate is optimal from the seller's point of view because a broker's sales activities cannot be easily monitored but might increase the price or reduce the time a house is on the market. A percentage commission might then act as an incentive and, up to a point, a higher commission might be better. I believe there is a lot of relevant economic literature on incentive payment schemes, but I don't know if anyone has applied it to real estate commissions.
Posted by: Martin at May 10, 2005 2:41:39 PM
I think signalling is the main problem, both here and in a very large number of economic situations. Price signalling is probably the main cause of inefficiency in service/information economics, and appears to me to be a VERY serious barrier to the real economic growth in wealthy nations.
Posted by: michael vassar at May 10, 2005 3:05:45 PM
